There is something called inflation. There is also deflation. And now, the market may be entering the early stages of reflation.
Inflation is when demand exceeds supply leading to prices rising. Some blame inflations on the FED and its easy monetary policies. The ease of money or the injection of liquidity into the financial system can lead to excess demand or a decrease in supply, which forces prices to rise.
Deflation occurs when there are too much supply and a lack of demand, which causes prices to fall precipitously. We last witnessed a bout of classic deflation during early-2020 when the Covid-19 pandemic led to a global shutdown as many parts of the economy saw a complete collapse in demand.
As the name implies, reflation is neither inflation nor deflation. It is normalization or the return to normal. Last year was an unprecedented year as the pandemic led to a global shutdown. As the Covid-19 vaccine goes mainstream and the economic restrictions begin to lift, the economy reflates.
Reflation is often associated with rising bond yields as the economy and interest rates return to pre-pandemic levels. While reflation is not necessarily bad for technology and growth stocks, the reflation trade tends to favor the economically sensitive value stocks and securities that rise with higher interest rates. Commodities, Basic Materials, and Financials are some of the biggest beneficiaries of the reflation trade.
Within commodities, Gold is the classic inflation hedge trade because of its store of value. However, silver may be a better reflation trade as it stands to benefit from an economic recovery. Yes, silver is a precious metal like gold. However, it is also used in electronics and industrial applications such as dentistry, batteries, glass coatings, LED chips, medicine, RFID chips, semiconductors, touch screen, solar energy, antibacterial water purification, and many others. On the ETF front, iShares Silver Trust (SLV – 24.33) tracks the price of silver. On the stock side, Pan American Silver Corp (PAAS – 33.70), Hecla Mining Co. (HL – 6.80), Glencore PLC (GLNCY – 7.93), and Glencore (Coeur Mining Inc (CDE – 9.97) are one of the largest silver mining companies in the world.
Copper is another commodity that benefits from a reflating economy. On the ETF side, iPath Series Bloomberg Copper (JJC) and US Copper Index Fund (CPER) can track copper prices. On the stock side, Freeport-McMoRan, Inc. (FCX – 39.96), Southern Copper Corp (SCCO – 75.77), and Rio Tinto Plc. (RIO – 79.58) are the larger copper-related mining companies.
The basic materials sector is the S&P 500 Materials (XLB – 78.78). It is one of the smaller S&P 500 sectors with a market weight of 2.71%. The largest holdings are chemical and industrial gases such as Linde PLC (LIN – 269), Air Products and Chemicals, Inc. (APD – 272.96), Sherwin Williams Co. (SHW – 716.97), Ecolab Inc. (ECL – 215.37), and LyondellBasell Industries NV (LYO – 107.63).
The financial sector (XLF – 34.57) has historically been sensitive to changes in interest rates, both to the upside (rising yields) as well as to the downside (declines yields). As mentioned, rising interest rates point to a recovering or a strengthening economy (reflation). Banks such as J.P. Morgan Chase & Co. (JPM – 155.37), Bank of America Corp. (BAC – 37.75), and Citigroup, Inc. (C – 74.22) stand to benefit from the steepening of the yield curve leading to rising net margin interests. Investment and brokerage firms such as Goldman Sachs Group, Inc (GS – 346.05), Morgan Stanley (MS – 83.86), and Charles Schwab Corp. (SCHW – 66.34) perform well during a rising interest rate environment as a healthy economy can lead to an increase in investment activities and interest income. Insurance companies can also excel as higher interest rates tend to lead to higher growth rates as the underlying bond investments yield higher returns. Insurers tend to hold stable and liquid debt to back the insurance policies they write. Improving the economy and rising consumer sentiment translate into more car purchases and home buying, which means more insurance policies written. Insurers include such companies as Allstate Corp. (ALL – 117.27), Metlife, Inc. (MET – 60.54), and Travelers Cos., Inc. (TRV – 157.34).
Beyond commodities, basic materials, and financials other sectors can outperform in a reflation scenario. Consumer Discretionary sector (XLY – 169.01) and Industrials (XLI – 96.19) tend to also strengthen as improving economic conditions, rising employment, and healthy housing market lead to more purchases in consumer durable goods, retailers, travel-related stocks, entertainment, Industrials, and others.
In summary, reflation means the normalization of economic conditions possibly back to pre-pandemic levels in the future. Whether it takes all of 2021 to do so, or next year, or further out, it is too difficult to call. However, reflation trades are likely to be centered upon stocks and ETFs that can participate in a strengthening economy and can do well when rates are trending higher. If the market is indeed in the early stages of a rotation into reflation friendly-stocks, then investors and traders will need to rebalance their investment portfolios to participate in this trend.