What’s a Reflation Trade, and Who Wins and Loses?

What’s a Reflation Trade, and Who Wins and Loses?

Inflation has been all but absent from much of the world for over a decade, but so-called reflation trades became all the rage earlier this year as economies started to recover from the pandemic and measures of inflation ticked higher. Loads of cash piled into strategies set to benefit from the trend. By mid-summer, however, investors started to worry that the trade had run its course.

1. What is reflation?

It’s the prospect of a return to global growth after the economic hit from the Covid-19 pandemic. When several drugmakers late last year revealed strong efficacy results for their vaccines, investors piled into assets that win in an improving economic cycle. Ultra-loose central bank monetary policies and more stimulus spending under President Joe Biden gave 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. This year, it sometimes has been used interchangeably with the word “reopening.” 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 also includes cruise operators, airlines and other travel and leisure companies that benefit from an end to pandemic restrictions. 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 recessions. 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 changed?

After leading the market higher all year, in July reflation trades began to struggle as benchmark 10-year Treasury and real rates -- which strip out the effect of inflation -- fell. The tech-heavy Nasdaq 100 Index climbed higher, while the cyclically-oriented Dow Jones Industrial Average began lagging. The reason was a belief among some investors that the strongest burst of economic growth was already a thing of the past. Other factors were a shift by the U.S. Federal Reserve in which it began discussions about tapering its bond-buying stimulus program, and new virus variants spreading across the globe that raised new worries.

7. Does that mean the reflation trade is over?

It’s too early to tell. Shares of tech companies were doing better in early July than their peers in industries like energy and banks, but that could change based off future economic data showing additional growth, or updated messaging from the Fed indicating that their easy monetary policy will continue longer than currently expected.

The Reference Shelf

  • Quants are ditching Treasuries as yields climb.
  • A QuickTake on the inflation debate.
  • Bloomberg Opinion’s Richard Cookson on the riskiness of the equity market.
  • A column from Brian Chappatta analyzing what Treasury yields at 1% means for markets.
  • Investopedia explains how inflation affects economies.
  • An article on the reflation trade starting to face trouble.

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