Investors are currently seeking to capitalize from a return to both inflation and global economic growth after the economic slowdown and deflationary period caused by the Covid-19 pandemic. Often mentioned in the financial press in recent months, this has been dubbed the ‘Reflation Trade’.
During the pandemic we naturally saw deflation, a general decline of the price level of goods. Now we have started to see reflation; price growth that has been stimulated by fiscal or monetary policy.
Vaccination-permitted reopening of economies, dovish central bank policy and a $1.9 trillion Biden administration fiscal package have boosted expectations for a surge of growth and a rise in prices. The reflation trade is focused on the assets that will benefit most from a return to economic growth and a pickup in inflation.
Expectations for inflation over the next 5 years have returned to their pre-pandemic levels based on the difference between inflation indexed and nominal treasury yields.
Which Assets Benefit from Reflation?
During reflation market sectors linked to economic growth typically do well. Among asset classes, reflation is generally favourable for commodities and stocks.
Reflation Trade and Stocks
Reflation benefits the stocks of banks and financials, industrials, energy and small-caps. Cyclical stocks such as car manufacturers, airlines, furniture retailers, clothing stores, hotels, and restaurants also tend to benefit . Riskier stocks and small caps typically do better than large caps during reflation. During a period of reflation, bond yields rise as investors expect a surge in economic growth and inflation.
Reflation Trade and Forex
Reflation benefits so called risk currencies and commodity currencies. These include the Australian, New Zealand and Canadian dollars which are all linked to commodities and benefit from a ‘risk on’ market environment. Meanwhile, the rising treasury yields present during reflation are bullish for the US dollar.
Reflation Trade and Commodities
Industrial metals such as copper typically do well during a period of reflation. Crude oil is another commodity that benefits as economic growth is expected to increase. Not all commodities are necessarily benefited by reflation. The rising interest rates in treasuries typical during reflation dampens the appeal of non-yielding assets like gold.
Reflation Trade and Cryptocurrency
Reflation takes place amid higher inflation expectations. Some investors view Bitcoin as a hedge against inflation due to its limited supply. In this way, the appeal of Bitcoin may increase in a reflationary period.
Reflation Trade ETFs
Bank stocks are expected to appreciate during reflation and the SPDR S&P Bank ETF (KBE) provides exposure to the bank segment of the S&P TMI (Total Market Index). Small cap stocks are also forecast to perform well during reflation and the iShares Russell 2000 ETF (IWM) offers exposure to 2000 small-cap domestic stocks in a single fund.
An increase in interest rates could cause housing prices to fall.
Reflation Trade Risks
Markets have started to price in the end of the pandemic. However, the virus is still raging in many parts of the world. The pandemic lasting longer than expected and fiscal spending cuts would threaten to undermine the reflation trade.
There is also concern that a tightening of credit in China could dampen the global reflation trade as Beijing officials look to prevent the economy from overheating. China’s “credit impulse”, which tracks the change in new credit issued as a percentage of GDP, has fallen below zero in recent months. Further tightening of credit would present headwinds for global economic growth.