Reflation And How To Exploit It
The most talked-about investing strategy these days isn't stuffing money in a mattress, it's the reflation trade-the bet that the world economy will rebound, driving up interest rates and commodities prices.
Even though the economy continues to struggle, investors are looking ahead to the time when the massive rescue efforts by central banks and governments gain traction.
They are focused on raw materials and commodity-related stocks that would benefit from the surge in infrastructure spending. They are looking to exploit potential bottlenecks in production that could lift prices and corporate earnings.
"Between the bailouts and the stimulus, it's pretty clear that we're going to have some inflation when we get out of this mess," says Roger lbbotson, founder of lbbotson Associates and chairman of hedge-fund manager Zebra Capital Management. He says, "It may not show up for another two years, after that I think it's quite likely and I think you should be positioning a portfolio against that."
Shawn Rubin, an adviser at Smith Barney in New York, has moved some clients partly into natural-resources stocks while using strategies to protect against a spike in inflation.
One way is to use options, where an investor is able to use relatively small amounts of money and take positions that would profit from a massive drop in Treasury prices or a near doubling in gold prices. "While in the short run such trades may not work, it's a long-term move," Mr. Rubin says. "You should buy insurance when it's cheap."
And despite the recentl altirity that lifted stocks 20% from their lows as of Thursday-the common definition of the return to a bull market, though they promptly fell again Friday-most investors expect a challenging environment well into next year.
But the Federal Reserve has taken dramatic steps to revive the economy and stabilize the financial system. It has lowered interest rates essentially to zero and is on track to pump more than $2 trillion into the credit markets.
On top of that, there is the $787 billion federal stimulus program coupled with a growing budget deficit. Around the globe central banks and governments are making similar moves.
Paul Kasriel, director of economic research at Northern Trust, says "the Fed will likely err on the side of ensuring that the recovery is sustained and usually that means they will be late in turning against inflation. The political sentiment will be toward inflation and in preventing deflation," he adds.
Mr. Liinamaa suggests investors keep a "survivor bias". That means "looking for names that have low cost structures and balance-sheet capacity to still be standing" even if demand doesn't recover soon. He cites steel producer Nucor as one example.
Already there are signs that the market is less worried about deflation. That's clearest in the market for Treasury Inflation-Protected Securities. Back in February, five-year TIPS were priced for a 0.5% drop in consumer prices, now that's swung around to a 1.35% increase.
"The magnitude of the expected inflation rise predicted by TIPS may be small, but the direction tells the tale," says John Hollyer, a co-manager of Vanguard Inflation-Protected Securities Fund.
"The fiscal and monetary stimulus are causing investors to say there's a decent chance the Fed will be successful and there will be an increase in inflation," he says.