What’s a Reflation Trade, and Who Wins and Loses?
(Bloomberg) -- Inflation has been all but absent from much of the world for over a decade, but so-called reflation trades have become all the rage in recent weeks, as trends in politics, economics and public heath come together. It’s a market movement that has clear winners and losers.
1. What is reflation?
It’s the prospect of a return to global growth after the economic hit from the Covid-19 pandemic. Ever since several drugmakers in November revealed strong efficacy results for their vaccines, investors have piled into assets that win in an improving economic cycle. Ultra-loose central bank monetary policies and hope for more stimulus spending under President-elect Joe Biden has only given more fuel to these bets.
2. Is it the same thing as inflation?
Not really. In markets, the term is used liberally to define an uptick in growth and price pressures after a broad contraction, often referring to the rate of change rather than the absolute level of prices. When it comes to inflation expectations in the real world and consumer prices, that’s a different ballgame, and one where there’s currently plenty of debate. Some investors contend that the no-expense-spared response by governments around the world to Covid and vows by central banks to keep rates lower for longer has put economies on course for inflation on a scale unseen in decades. Others say the pandemic is only intensifying trends seen in recent years, where price increases have been absent thanks to weak economic growth, demographics and technology.
3. How do you trade it?
Reflationary trades tend to involve assets exposed to faster economic growth, price pressures and higher yields. Riskier equities tend to benefit at the expense of nominal bonds, or those not protected against inflation.
4. What kinds of assets do well?
In the stock market, it’s small caps and cyclical sectors such as banks and energy producers. This time it’ll also include cruise operators, airlines and other travel and leisure companies that benefit from an end to lockdowns. For income-oriented investors, trades that capture the widening spread between short- and long-dated bonds are popular. Another way to play the trend is through breakevens, a market-derived measure of inflation expectations.
5. When have reflation trades worked?
It’s the go-to trade when economies emerge from a recession. In 2009, when growth was near the trough during the global financial crisis, small-caps and value stocks also had their moment in the sun. Since then, however, reflation trades have lost steam as rates of inflation and economic growth remained stubbornly low.
6. What’s driving this now?
It’s a combination of the new political landscape in the U.S. and the rollout of Covid vaccination programs, as investors anticipate the bursting forth of pent up consumer demand as the virus wanes.
7. What political events?
First, Joe Biden’s defeat of President Donald Trump, and the triumph of Democratic party candidates in two Senate races in Georgia on Jan. 5. Wall Street has been fixated on the Georgia races because they determined which party controls the Senate. Since Democrats already controlled the House of Representatives, the Georgia victories make it easier for Biden to push through his agenda of boosting infrastructure and putting cash in the pockets of the American middle class. After the vote, Goldman Sachs Group Inc. economists predicted the U.S. economy would expand 6.4% this year, faster than the 5.9% previously expected. The bank also says Biden will be able to deliver a fiscal stimulus package of $750 billion this quarter, $300 billion of which will be in the form of checks to households.
8. What are the trade’s pitfalls?
Markets are already pricing in the end of the pandemic, but with infection counts still hitting records in many countries and the vaccine rollout in its infancy, it could be a long time before normal life returns. There’s a risk that these optimistic projections for economic growth won’t materialize, especially if more people fall seriously ill to the virus, health officials struggle to deliver the vaccine or governments pull back on aid.
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