Reflation trade’s effects on investors
Joel Dresang: Kyle, for months I’ve been hearing about a reflation trade that’s been affecting the financial markets. I know that inflation is a period of rising prices, what is reflation?
Kyle Tetting: Reflation is this idea that prices are rising more quickly, that the rate of inflation is picking up. What we’ve really seen is that as the economy has improved since the recession, that as employment has picked up and wage growth has picked up a little bit, that the rate of inflation is starting to increase a little bit.
Joel: So, tell me more about what’s driving this acceleration of inflation.
Kyle: In addition to some of the economic improvements, we’ve also seen now some expectations for infrastructure spending, expectations for changes to the tax code, as well as expectations for some deregulation in the banks and other industries. That can really have an economic impact as well, potentially driving inflation higher as well.
Important to remember that right now it’s based on a lot of expectations, but if we do see some of that come true, we’ll see some inflation pick up there potentially as well.
Joel: Are there any global forces at play?
Kyle: Yeah, there absolutely are. We had some concerns about growth in China that seemed to have been a little bit overblown perhaps, and things have picked up a little bit. Certainly not out of the woods there, but definitely some signs of optimism. I think more importantly, Europe and Japan especially have started to emerge now from what had been a pretty protracted period of at least slow growth – so those kinds of things now feeding into the expectations for inflation as well.
Joel: So, as an investor, why should I care about this expectation of rising inflation?
Kyle: Inflation really erodes your purchasing power, and that’s one of the reasons that as an investor we put stocks in a portfolio is because they have the ability to overcome inflation.
So obviously, if we’re seeing the rate of inflation pick up, or if we expect the rate of inflation to pick up, we really need to reassess the way that we’re building portfolios to make sure that you’ve got an appropriate allocation to overcome that potential inflation.
Joel: So, how have the financial markets been responding to this reflation?
Kyle: Especially since the election, but certainly in the last few months, we’ve seen that the markets have really run quite a bit higher. You look at pretty much any measure of stocks, and they’ve moved pretty drastically higher. However, I think it’s important to remember that it’s based on expectations for these changes – and not necessarily what we’ve actually seen happen.
Joel: So what, if anything, should I be doing about reflation?
Kyle: I think it’s important for investors to remember why they hold the portfolio they hold. They have a particular tolerance for risk. And, for them, that likely means that they don’t want to take too much action one way or another. Also, important to remember that for many investors, we’ve already been increasing exposure to stock just simply because it made sense in the current rate environment, and there were a number of opportunities out there. I don’t think investors need to respond to the potential for reflation. I don’t think they need to try and take advantage of the reflation trade. They probably already have. But I think it is important to remember again that risk tolerance and why you hold the portfolio you hold.
Joel: What about on the bond side?
Kyle: So, inflation does tend to accompany improving economic growth. So what that typically means is that interest rates tend to be rising in that environment as well. It’s going to provide a little bit of a head wind for your bonds. But, again, there’s a reason for those bonds in your portfolio. So, it’s kind of difficult to say that you should be getting out of that piece of your portfolio – simply because of an expectation.
Joel: Is it a good time to rebalance?
Kyle: You know, it’s always a good time to rebalance, especially if you haven’t looked at your portfolio in a while. But I think especially now as you’re looking at the stock market having had a very nice run, as you’re looking at the expectation for growth but not really seeing any of the things that would signal that it’s imminent, you know, now may be a great time to say, “Let’s take some profits on what we’ve made. Let’s start to match up our liabilities with already getting some cash for those liabilities.” So yeah, absolutely, now is a good time to rebalance.
Joel: But bottom line is we should understand what this reflation trade is and not overreact.
Kyle: Yeah. Again, it is based on expectations right now for what may be some above-average growth – at least from what we’ve seen. And so, I think investors just need to keep in mind that anything could happen from here and that they have a balanced portfolio for a reason.
(initially posted April 11, 2017)