Investors have a second bite of the cherry when it comes to the reflation trade in Europe, according to Schroder’s fund manager James Sym.
Despite inflation expectations falling this year, the trend remains broadly upward and investors that have yet to take on inflation protection still have time to do so.
The manager of the £1.3bn Schroder European Alpha Income fund said he has been talking about the reflation trade for over a year, during which time the fund has outperformed the IA Europe ex UK sector average but has underperformed the wider FTSE World Europe ex UK benchmark.
“The reflation trade is something we talked quite a bit about last year. At the time I said I felt that inflation was coming back and that meant high nominal growth, which would have big implications for portfolios,” he said.
“The chart we use to gauge this – and the reason I use it is because it is the same one that Mario Draghi uses it – is the five-year forward inflation expectations: i.e. what does the market think inflation is going to be between five and 10 years into the future.”
Source: Schroders
As the above chart shows, in the second half of 2016 expectations increased significantly, as highlighted by the green bubble.
However, rather than kicking on, inflation expectations have fallen back throughout the course of 2017 and the manager thinks this gives investors another chance to buy inflation protection.
One reason for his optimism is the potential for wage growth to pick up – something that has eluded markets for some time.
“We are looking at two sides of the economy now. This is the labour side in Europe and shows wage growth. The dark blue line shows pay rises and the light blue line shows whether there are more or fewer people in employment,” Sym said.
Source: Schroders
“Last year it was kind of normal and that is okay for this argument because bond yields are about zero but now we are starting to look pretty tight and that corroborates what companies tell me – pretty much all are telling me that wage inflation for next year is going to be higher than 2017.”
Turning to the capital side of the economy, Sym noted that capital utilisation – or how full the factories are – are bordering on full capacity.
“You can see both the global financial crisis in 2008 and the eurozone crisis in 2012 led to an under capacity but 10 years of not investing in fixed assets in Europe – so company capex [capital expenditure] has been very low for 10 years – means that there is not much slack left and the factories are pretty full,” the manager said.
Source: Schroders
As such, he said that it is possible that we are closer to rising inflation in Europe than we were last year, as both fundamentals on the demand and the supply side look supportive.
“Nothing I see that changes my medium-term view on inflation and higher bond yields and less quantitative easing [QE],” Sym said. “So the way I look at this is we have a second bite at the cherry and we can position for that going forward and we can use that reflationary period [last year] to test how various assets performed.”
However, after a decade of low inflation, low interest rates and QE from European Central Bank investors and fund managers appear to all be leaning one way – towards growth stocks.
Sym said he ran a study looking at the performance of the 10 largest funds in the IA Europe ex UK sector over a three-year period to July last year.
He chose this period as it was the low point in inflation expectations as shown by the first graph and, during these three years, five of the top 10 funds were in the first quartile of the sector.
However, during the period when expectations rose – the first reflation trade last year – of the 10 biggest funds in the sector, six were in the fourth quartile in that period.
“If I am right and inflation starts to come back and bond yields at 40 basis points for a German 10-year bund are ludicrously low, then we need to know how our clients are going to do. The message is very clear – there is very little inflation protection in clients’ portfolios,” Sym noted.
As such, he has positioned his portfolio accordingly, with the 35.2 per cent invested in financials and much of this in specifically banks.
Rising rates tend to point to a strengthening economy leaving banks with fewer non-performing assets as consumers find it easier to make loan repayments.
It also means that they can earn more from the spread between borrowing and lending, as they typically borrow from the government at a lower rate and loan at a higher rate.
“I think it is well known that banks and financials tend to correlate positively with higher bond yields and inflation expectations, so that is one area of the equity market that we are very overweight and we think can work,” the manager said.
The other area he is highly weighted to is telecommunications stocks, which make up 17.7 per cent of the portfolio.
“I think it is a really interesting sector – firstly I think it offers inflation protection but secondly it is massively out of favour so as a contrarian this is quite a happy hunting ground,” he said.
“They have just gone through their previous relative low which was post the TMT [technology, media & telecommunications] bubble [in 2001] just as the fundamentals are hitting new highs.”
Source: Schroders
For the last few years, telecommunication stocks have underperformed as the revenues have fallen, partly due to increased regulation and partly due to higher costs.
However, they are now at a turning point, with regulations allowing more slack for higher returns and capital expenditure falling.
“These businesses have been digging up the roads to every house in the country. 100 years ago they dug up the roads to put a copper line to every household and today it is glass fibre. That is an incredibly expensive thing to do but you only do it once every few decades.
“So it is pretty harsh to value these companies on their current cashflow when they are making this once in a generation expenditure, but that is what the market is doing at the moment.
“If I think we are getting back to more normal levels of investment then what you should see is a massive inflexion in the cashflow generation of these companies.
“It already started to turn positive last year and I think we can easily go back to high single digit or even double-digit growth because they are coming to the end of the investment phase and should take out a lot of cost.”