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. It’s essentially 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 may reflect monetary policy designed to stimulate spending and halt deflation. In today’s economy, proponents of the “reflation trade” are betting on some economic sectors primed to take off as the United States reopens post Covid, following fiscal stimulus, an increase in consumer spending surges, and a decrease in unemployment.

The last time that reflation trades outperformed was in 2009, as the economy recovered immediately following the Global Financial Crisis.

Reflation vs. Inflation

While they’re both characterized by rising prices, reflation and inflation 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.

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.

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 see reflationary dynamics in sectors like hospitality or dining that were hit hard by the pandemic, along with travel and tourism, and more indirectly affected sectors like energy and materials.

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 turns 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.

Reflation Trade Sectors

While hospitality stocks might make sense for investors considering a reflation trade in today’s market, 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.

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.

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.

Ongoing Uncertainty

Reflation is a possibility in today’s economy, but it’s not certain. The path of the Covid-19 epidemic is hardly certain and the improving economy still faces many hurdles. Some feel that the markets have already priced the recovery into asset prices, providing little upside to reflationary trades and increasing the risk of actual inflation.

While some investors are looking for stocks and other investments based on reflation, others believe that we’re in a period of inflation, instead, and are preparing for a possible market correction.

Recommended: How to Invest During a Recession

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, either via individual stocks or by buying sector-specific exchange-traded funds (ETFs) or mutual funds.

Whether you believe in the reflation trade or not, an easy way to get started building your portfolio is by opening a brokerage account on the SoFi Invest® investment app. With just $5, you can start investing in an array of assets, including stocks, bonds, ETFs, and cryptocurrency.

Photo credit: iStock/eugenesergeev

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