The Trump ‘Reflation’ Trade
Today, markets are driven as never before by momentum, not fundamental analysis of the economy and earnings. The key to momentum is what we call the narrative, the story investors tell each other to generate the herd behaviour that drives momentum trades.
Gold is just as much affected by narrative as any other asset class, if not more so. Gold is the go-to asset when financial uncertainty is on the rise. Gold is the risk-off safe harbour for preserving your capital. It doesn’t matter what the markets are worried about…inflation or deflation, higher interest rates or lower, currency devaluations, trade restrictions or capital controls…gold and gold stocks are the assets investors buy with both fists when risks are seen to be increasing. So, investors need to ask if the current narrative driving markets favours taking risks or running the other way.
For the past six months, markets have certainly embraced taking on more risk. Stock prices are up and valuations are at extreme levels despite faltering earnings, Fed rate hikes and a slowing economy. It looks like a mania to us. Driving this performance is a narrative that goes back to the election of President Trump and sounds something like this: President Trump will follow through quickly on his promises of large tax cuts and higher spending on infrastructure and defense, thereby pumping up corporate profits; inflation will accelerate; the Fed will raise rates faster than inflation; and the dollar will soar. The bottom line of this narrative: Buy stocks and sell gold. This is the so-called Trump reflation trade.
There are some obvious logical problems with this chain of ‘logic’. First, the Fed has never pre-emptively raised interest rates faster than inflation. The Fed always follows the market. Second, a higher dollar depresses export earnings and reduces inflation. We also thought from the very beginning that there was almost no chance such a program could actually pass. It seems we were right about that. Even with Republican majorities, political gridlock continues. The dollar has weakened and the economic data over the past three months has not been at all encouraging.
The market is now beginning to look for a new narrative. Investors are starting to take in the facts that were screened out or downplayed while the accepted narrative was in charge. What will a new narrative contain? We think there are a number of possible components: the economy is slowing; corporate earnings have peaked; the stock market has more downside than upside; and more Fed rate hikes are less likely. This narrative supports a risk-off investment strategy unlike the one that we have seen in the past six months…a strategy that should prove to be gold-friendly.
If we are right, gold and gold stocks are going to come back into favour. In that case, we think the gold stocks to own will be the ones like Paramount that have substantial gold resources on a per share basis.