What’s the Reflation Trade?
The reflation trade is a bet that certain sectors of the market perform well immediately after a recession or economic crisis. Essentially, it’s a bet on cyclical stocks at the beginning of a market recovery.
Reflation is the inflation that typically comes immediately after a low-point in the economic cycle — often after economic stimulus, and the reflation trade is the purchase of specific stocks or sectors believed to outperform in that type of environment.
Reflation vs Inflation
While both reflation and inflation are characterized by rising prices, they are not the same thing.
Reflation is a recovery of prices lost during an economic downturn along with employment growth, and many economists see reflation as a healthy sign of an improving economy. It often accompanies economic stimulus, and may reflect monetary policy designed to stimulate spending and halt deflation.
Inflation, on the other hand, does not look at employment or any other economic factors. It is the rise in prices beyond their “normal” range, and poses a threat to economic recovery, since it can reduce the purchasing power of consumers and make it more expensive to borrow money.
Reflation is also different from what happens during stagflation, in which prices go up but wages don’t follow.
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Understanding Reflation Trade Opportunities
Reflation doesn’t just mean that the market as a whole will rise as economic activity returns to normal or even higher levels. Instead there’s a focus on certain sectors as they reflate after a decline.
For example, some investors might see reflationary dynamics in sectors like hospitality or dining during a pandemic, along with travel and tourism. It may also be noticeable, under those circumstances, in more indirectly affected sectors like energy and materials.
Again, assuming an economy suffers a pandemic, part of the reflation trade could be a switch from purchases of goods to services, as people go out more, whether it’s movie theaters, restaurant meals, theme parks and hotels. These are the sectors that would perform well if the reflation thesis turned out to be true.
Investors interested in the reflation trade can invest in individual stocks, or get more diversified exposure by investing in sector-specific exchange-traded funds (ETFs) or index funds.
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Reflation Trade Sectors
While hospitality stocks might make sense for investors considering a reflation trade, there are other sectors that typically perform well in most deflationary environments. Here’s a look at a few of them:
Financial Stocks
Banks and other financial institutions tend to do well after an economic recession, since they can benefit from both higher interest rates and ramped up consumer spending.
Value Investing
Companies that deliver steady, long-term growth often get undervalued during economic downtimes, meaning that they’re poised for better performance as the market begins to improve. That’s the logic behind value investing.
Bonds
When interest rates are rising–in either the short- or the long-term — investing in bonds may benefit from a reflationary market.
Commodities
Since commodities tend to perform well during both periods of inflation and periods of economic growth, they’re a favored investment among those looking for a reflationary trade. As such, commodities trading could be an attractive area in a reflationary market.
Small Cap Stocks
Investments in small cap stocks tend to increase in value after recessions or during periods of growth, making them another asset that investors might consider in a reflationary market.
💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.
The Takeaway
The reflationary trade is a bet on specific sectors of the economy or certain types of asset classes in the aftermath of an economic downturn. If you’re interested in incorporating the reflation trade into your portfolio, you could do so either via individual stocks or by buying sector-specific exchange-traded funds (ETFs) or mutual funds.
But note that the economy is a complicated thing, and that there are cycles it naturally takes, but it’s also susceptible to all sorts of other events. That includes natural disasters, political changes, or even pandemics and other global crises. With that in mind, it can be difficult to be sure of what sort of environment the economy is in, exactly, at any given time.
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