‘Reflation Trade’ Looks Promising. These Assets Look Too Hot. - Barron's

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Growth stocks, sought out as havens during the pandemic, have been falling.

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Markets have suggested that the economy is truly recovering. If it continues, assets that usually perform well when conditions are more worrisome—like safe bonds, gold or even growth stocks—should see continued weakness.

For growth stocks, especially, the pain may have just begun.

The reflation trade, when prices of assets most sensitive to firming inflation and economic expectations perform relatively well, kicked into gear months ago, on Sept. 23. Stocks, one of the usual beneficiaries, have risen since then, lifting the S&P 500 by 20%. Value stocks, more sensitive to changes in economic demand than growth stocks, are exhibiting typical behavior, up 60%, as illustrated by the Russell 2000 Value Index. Commodities like oil have surged.

Safer assets, those that gain when times get tough, are performing relatively weakly. Gold is down about 3% since Sept. 23. Yields on 10-year Treasury debt, which move inversely to its price, have effectively doubled to 1.36% from 0.67%.

The economy is indeed coming back. The unemployment rate is just above 6.3% from almost 15% in May, according to the Bureau of Labor Statistics. Efforts by the Federal Reserve to reduce interest rates and keep them low have kept cash flowing into corporations and buoyed the housing market.

Trillions of dollars of fiscal stimulus have boosted consumer and small businesses’ savings accounts, which means a wave of spending and hiring could take place when the coronavirus recedes enough for economies to reopen, Millions of people a day are receiving Covid-19 vaccine shots.

The reflation trade still looks promising. Not only do developments on the health and stimulus fronts remain positive factors, but some commodities, such as copper, still look underpriced relative to gold. Value stocks, many of which are trading at tolerable valuations, still have plenty of potential for earnings to rise.

But it isn’t as if relatively defensive assets are trading where they should be. Blow out the timeline a little further and many are still ahead of the reflation assets since just before the pandemic.

Growth stocks, which investors tend to favor when times are tough because they often achieve strong gains in earnings regardless, have outperformed. Since mid-February 2020, the Russell 2000 Growth Index is up roughly twice as much as its value counterpart. Gold is up almost 10%, though copper has indeed beaten that gain by roughly sixfold

The 10-year Treasury bond’s price is still higher than it was in mid-February last year, when the yield was 1.58%. Furthermore, the real yield—the bond’s yield minus the expected rate of inflation—is still deeply negative. Real yields historically have been positive, implying that if expectations for inflation don’t change, bond prices should fall, sending yields higher.

The bottom line is that many defensive assets may don’t carry the most favorable risk-reward profile anymore. “Instead of ‘looking up’ for the biggest beneficiaries as growth improves, the more pressing issue for the markets may be ‘looking out’ to havens that have so far ignored the improving economic story,” wrote Andrew Sheets, chief cross-asset strategist for Morgan Stanley, in a research note.

One caveat: Many growth technology companies have gotten a tailwind from on-the-ground developments during the pandemic that has benefited their stocks beyond what might be expected from buyers seeking shelter during hard time. Businesses and consumers are now more aware of the efficiency of trends like cloud computing and e-commerce.

Still, as interest rates rise, a dynamic that weighs more heavily on growth stocks than on value, growth stocks’ outperformance may keep unwinding. The reflation trade has legs, but a balanced investment strategy, a so-called barbell approach, seems reasonable.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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‘Reflation Trade’ Looks Promising. These Assets Look Too Hot. - Barron's
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