Hedge Funds See Something in the Reflation Trade They Don’t Like


While wagering on an economic rebound has been the stock market’s biggest bet since November’s presidential election, one group of investors has hung on to its chips.

Despite a rally of at least 40% in energy and financial shares over the five months, hedge funds -- on average -- have steadfastly shunned stocks in the reflation trade, favoring instead companies seen as resilient during an economic slowdown. Their exposure to cyclical shares sits at one of the lowest levels in a decade relative to defensive ones, industry data compiled by Bank of America Corp. show.

Hedge Funds See Something in the Reflation Trade They Don’t Like

Client data at Morgan Stanley show a similar if less pronounced pattern. After peaking near the end of 2020, the industry’s net exposure to the reflation strategy has retreated to the 78th percentile over the last 12 months, according the firm’s prime brokerage unit.

What’s driving the aversion isn’t obvious. One theory is that hedge funds aren’t buying the return-to-normal narrative despite the rollout of vaccines. Last year, when retail investors rushed to hunt bargains in beaten-down groups like airlines and hotels, professional speculators were hesitant to chase pandemic-ravaged companies.

Another explanation holds it may be related to apprehension that economic acceleration, propelled by monetary and fiscal support, will lose steam once the latest federal spending wears out. Mike Wilson, an equity strategist at Morgan Stanley, is an ardent proponent advocating a shift to stocks better positioned to weather potentially disappointing economic data, such as consumer staples.

“This is the time to upgrade the portfolio and shift toward quality ahead of slowing rates of change in a number of macro indicators,” Wilson wrote in a note to clients Monday.

Whatever reason is behind hedge funds’ cautious stance, it’s starting to reverberate in the broad market. Over the past month, utilities and consumer staples have taken over leadership from energy shares while a spike in bond yields stalled even as hiring and services-sector data outstripped estimates.

To Tony Dwyer, a strategist with Canaccord Genuity, investors should take advantage of any pullback in the reflation trade to add exposure.

“The only way to view this, in our view, is as a ‘Capital V’ recovery that is in the early innings, and the only thing that could stand in the way would be another shutdown of the economy to contain new Covid-19 strains or a policy mistake by the Fed,” said Dwyer. “Neither appear imminent.”

When compared to history, hedge funds’ exposure to financial and energy shares now trails all other sectors, data from BofA show. Such skepticism bodes well for these stocks that are under-owned and traded at lower multiples relative to earnings or book value, according to the firm’s strategists led by Savita Subramanian.

“Hedge funds are yet to embrace rotation to value which leaves room for increased positioning in the coming months,” they wrote in a note last week.

©2021 Bloomberg L.P.

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