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Steady growth and the prospect of tax cuts are keeping the reflation trade alive

  • U.S. stock indexes hit record highs; stock markets in Japan and China hit 52-week highs. Hong Kong's market hit two-year highs.
  • The global economy is continuing to expand. This has been a good year, and growth will continue into 2018, even if it is not quite as strong in every part of the world.
  • The reflation trade is expected to continue into the fourth quarter, with double-digit earnings growth expected in industrials and materials, and energy expected to continue to rally as well.
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September saw the reflation trade come roaring back, and it's likely to have legs in the fourth quarter.

By "reflation" I mean expansion, as in expanding economies, not necessarily inflation.

Bulls are betting that the combination of slow but persistent global growth and prospects for tax cuts in the U.S. will keep the markets at or near record highs in the fourth quarter.

In September, we saw firmer global inflation readings, higher bond yields, higher oil, a turnaround in the dollar, central bankers talking more hawkishly, and -- the cherry on top -- prospects for tax cuts in the U.S.

That's reflation.

U.S. stock indexes hit record highs; stock markets in Japan and China hit 52-week highs. Hong Kong's market hit two-year highs.

What's driving the turnaround, and will it continue into the fourth quarter?

First and foremost, the global economy is continuing to expand. This has been a good year, and growth will continue into 2018, even if it is not quite as strong in every part of the world.

The OECD, in its quarterly assessment of the global economy last week, noted that industrial production and trade was picking up, and there was a further acceleration in the rebound of tech spending. In the U.S., they expect growth to be supported by stronger consumer spending and business investment.

The OECD raised global growth projections for 2018 to 3.7 percent (from a prior 3.6 percent estimate in June). They kept current estimates the same for the U.S. and slightly lowered it for India, while raising them for Japan, China, and the Euro area.

2018 Growth Projections

Global: up 3.7 percent

U.S. up 2.4 percent

Euro area: up 1.9 percent

China: up 6.6 percent

India: up 7.2 percent

Japan: up 1.2 percent

Source: OECD

These stronger economic numbers are showing up in the U.S. stock market, as sectors associated with growth outperformed the S&P 500 in September:

Reflation trade: sectors (Sept.)

Energy up 9.8 percent

Banks up 7.5 percent

Materials up 3.3 percent

Industrials up 3.6 percent

S&P 500 up 1.5 percent

That reflation trade is expected to continue into the fourth quarter, with double-digit earnings growth expected in industrials and materials, and energy expected to continue to rally as well.

Hurricanes Harvey, Irma and Maria had a modestly negative impact on earnings for several companies in the third quarter (airlines and retailers in particular), but the reconstruction efforts may bring a boost to some sectors (materials, autos) in the fourth quarter. More on that here.

Aside from the global growth story, two other issues will determine the fate of stocks in the fourth quarter.

1. The prospects for tax cuts have been a notable influence on stocks in the second half of the month, with the Russell 2000 notably outperforming, since small caps would greatly benefit from tax cuts. More on tax cuts and stocks here.

2. Technology has far and away led the market this year, with gains of roughly 25 percent. However, not all tech is created equal. The Street is continuing to bet on the massive expansion of the semiconductor business, so analysts are expecting the semiconductors & semiconductor equipment subsector earnings to be up 25.7 percent in the fourth quarter, according to Thomson Reuters, with big growth from Micron, and strong growth from Nvidia, Analog Devices, Applied Materials, Lam Research, Broadcomm, and AMD.

There are also very large bets on IT Services companies with strong growth expected from Mastercard, Visa, and Paypal, for example. That subsector is expected to see earnings growth of 11.9 percent.

One big wildcard: Apple, whose earnings are expected to grow 12 percent in the fourth quarter, but the stock slid 6 percent in September as doubts grew about how many people would be buying the new Apple iPhone 8 and X

Speaking of wildcards, the two major risks to the market are North Korea and the Fed. The market has fluttered — and recovered — every time there has been some kind of ratcheting up in tensions between North Korea and the U.S. And the market reacts to the Fed's handling of its own balance sheet reduction and decisions on rate hikes.