During the past few weeks, a new phrase has seized investors’ imagination, shutting out talk of almost anything else: the reflation trade – buying into assets likely to benefit the most from a return to economic growth.
The technology stocks that have driven recovery and growth since the 2008 financial crisis are suddenly out of favour. In their place, long-maligned value stocks, more associated with the old economy than the new, have muscled their way into the limelight.
“With the reflation trade, you’re suddenly looking at the procyclical areas again,” says Joshua Mahony, a senior market analyst at IG Group, the UK-based spread-betting company. “It’s almost a mirror image of what we’ve been used to over the last few years.”
Interest in older-economy stocks has grown in tandem with prospects for a return to growth following the Covid-19 pandemic, and the collapse in global demand that it triggered. The recent spike in 10-year Treasury yields is a clear expression of the new-found optimism in an economic rebound. Meanwhile, expectations of higher inflation have returned, and are now at pre-pandemic levels.
But how sustainable is the reflation trade?
And, even if it proves short-lived, how can investors best take advantage?
Daniel Lacalle, Chief Economist and Investment Officer at the Madrid-based asset manager Tressis Gestión, remains cautious about how long the current interest in value stocks will last. He argues that the multiple deflationary factors that were present before the Covid-19 pandemic, such as overcapacity, the slowdown in the energy market and technological disruption, which tends to drive prices down, are set to return in the second half of the year.
“These are all structural factors,” Lacalle says, “and their return means that anyone looking at the reflation trade has to think short-term and very tactically.”
When it comes to the UK, Mahony argues that “thinking tactically” should include financial institutions because British banks are more centred than their US counterparts on the retail market, which aligns their fortunes closely to the country’s economic cycles.
Just as when you see bank stocks suffering during a downturn, so you are going to see them coming back during a boom.
Joshua Mahony
Senior market analyst at IG Group
With strong signals from the government of continuing supportive economic policy and doubts over Britain’s exit from the EU now settled, analysts say there are clear short-term tailwinds for the reflation trade.
“With a deal, visibility has improved relative to a World Trade Organization-type of exit and exposure to the region remains low, leaving room for further inflows,” Jean-Damien Marie and Andre Portelli, Co-Heads of Investment at Barclays Private Bank, wrote in a research note last month.
Commodities is a second area where opportunities could lie — in particular, the industrial base metals that feed into the industrialisation policies set out by China’s economic growth plans as well as the infrastructure packages outlined in the US and UK.
All of that should continue to play to the strengths of the UK’s mining stocks, which have already recovered from the lows hit during the pandemic but still find themselves with plenty of headroom for growth in the coming months.
Within the transport sector, Mahony argues that companies with more of a domestic focus, such as many of the smaller US airlines, are likely to recover faster because they are less exposed to potential quarantine regulations on international travel. The same is true of local bus companies, many of which have received strong support from the government.
In general, however, buying value stocks with global exposure can play strongly to the reflation-trade theme because the Covid-19 pandemic hit international supply chains as well as industrial demand in the world’s biggest economies.
Lacalle of Tressis Gestión says that one obvious play is oil and gas stocks, in particular those whose fortunes are closely bound to the international price of oil, such as exploration companies rather than the big oil companies.
The oil majors have a much more diversified business because of all of their downstream activities. That makes them less exposed when commodities fall but it also makes them less positively exposed when they recover.
Daniel Lacalle, Chief Economist and Investment Officer at the Madrid-based asset manager Tressis Gestión
As to how long the opportunity will last, Mahony of IG Group suggests acting sooner rather than later. “If you look historically, the relationship between value and growth is in favour of growth, and that will kick in again,” he says. “A lot of these value stocks are just trying to recover the losses they have sustained since Covid, and once that plays out, that’s when things will stabilise.”