The Reflation Trade: What Is It?
As calendars have turned to 2021, headlines have trumpeted the “reflation trade.” This is not new. Talk of reflation is very common as markets rebound from a major pullback. Even so, it’s been a while since our last major downturn, which may beg the question, what is reflation, and what does the reflation trade mean for the markets?
What is Reflation?
Reflation encompasses policies aimed at increasing prices in order to achieve economic growth and full employment. Think of it as purposefully trying to increase inflation to stated targets (in the US, the general stated policy from the Fed is to aim for 2% inflation). G.D.H. Cole once noted that “Reflation may be defined as inflation deliberately undertaken to relieve a depression.” In order to create reflation, policymakers use either fiscal or monetary policy to expand output and combat deflation, or forces that may be driving prices down. Reflation as a policy aim usually comes out of a recession or other period of economic uncertainty. Common tools utilized:
- Reducing taxes
- Lowering interest rates
- Increasing the money supply (i.e., printing more money)
What is the Reflation Trade?
The reflation trade, broadly speaking, is trading into sectors that expect to be positively impacted by the policy tools mentioned above. This can take place throughout the financial markets, but we will focus on stocks and bonds.
On the stock side, sectors that tend to perform well in a reflationary environment are cyclical and value stocks that historically outperform during market recoveries. Financials, energy and small stocks may be expected to do well as governments push to get economies restarted with the global rollout of the vaccine. One could argue this dynamic already began in the 4th quarter of 2020, with energy, financials and especially small stocks outperforming the broader market. However, these types of stocks still are trading at a discount versus their more growthy counterparts. These sectors also are typically overrepresented in value portfolios, which helps explain why value tends to outperform in economic recoveries.
With policymakers sending out another round of stimulus and the Federal Reserve continuing to keep interest rates on the floor, there appears to be continued opportunity in these value sectors as the reflation dynamic continues to play out. As we’ve discussed before, valuations for stocks matter. It’s just a matter of when they start to matter. This reflation concept may be the catalyst to see investor preference change from what has worked (like growth, US stocks, and big stocks) to other parts of the market that are key to a good, diversified portfolio.
In the bond world, investors expect interest rates to rise in a reflationary environment, so they’ll sell old bonds at lower yields in favor of bonds with higher yields. Since the yields on 10-year treasuries bottomed out in August at nearly 0.5%, they have inched upwards, closing out 2020 at 0.93%. While many commentators cast some doubt for a major resurgence in bond yields, most expect them to continue to creep up. The likely expectation in this type of environment is bonds can muddle along slowly, which is not unique to the history of bonds. Like the famous childhood story, bonds are much more like the tortoise than the hare.
What Does this Mean in 2021?
As we look into the new year, how does reflation impact your portfolio? Well, as governments continue to cope with the damage wrought to economies by the Covid-19 pandemic, the tools they are using are largely reflationary. The Federal Reserve has kept rates at zero, and Congress has passed legislation that injected trillions of fiscal stimulus into the US economy. These measures could very well lead to the reflation trade into small and value stocks to continue to add to the edge they started having last quarter.