Is The Reflation Trade Over?
About the author: Chris Abts is the President & founder of Cornerstone based in Reno, NV. He helps people to better manage their wealth so they can focus more of their time on what truly brings meaning and fulfillment to their life. Abts is also a best-selling author and TV show host of Redefining Retirement, which airs every Sunday evening at 5:30pm on KTVN Channel 2.
For simplicity, the easiest way to describe a typical reflation trade is by comparing it to a beach ball. When a recession happens, the beach ball (our economy) deflates. However, government stimulus and low interest rates act like an air pump, and over time, the beach ball re-inflates.
Economic growth and increasing inflation (caused by easy money policy) become the “air” that re-inflates the economic beach ball. From an economic standpoint, these are usually considered good things. As a result, markets go up and investors benefit from this financially by adding risk to their portfolio by increasing their exposure to growth stocks. Typically, during a normal reflation period, everything goes up, regardless of what else is happening in the world. Think back to what happened during the prior reflation period from 2003 to 2006.
However, this reflation is different. It’s been eight years since the end of the last financial crisis, yet our economic beach ball is only half full. At this point, we’ve pumped in the “air” of accelerating economic growth, but we haven’t yet pumped in any “air” from inflation.
Regardless, stocks are currently at all-time highs, and market valuations are about as stretched as anything we have seen for a very long time. Barring any big surprises such as the potential Trump tax cuts or perhaps significant infrastructure spending, it’s highly unlikely that we are going to experience a material acceleration of economic growth. In other words, it is highly unlikely we will see GDP of 3.5% to 4% given the current demographics in our country. Specifically, approximately 80 million baby boomers moving toward retirement and currently no significant demographic group to replace their previous spending habits.
Returning to our beach ball analogy, if inflation finally does increase, the time of euphoria will decrease, as the other half of our beach ball re-inflates. And given current valuations, stock prices and economic growth are nearing reasonable ceilings. Therefore, the risk is that after a short period of time, inflation could over-inflate our economic beach ball, potentially causing a bubble to develop that could result in the bursting of the beach ball. Then, the Fed’s decision to increase interest rates could possibly signal the beginning of the end of this eight year expansion.
And unlike most reflations, we’re probably not going to enjoy an easy rally that lasts for years. We may be much closer to our economic beach ball bursting than in previous market cycles. Bottom line, at this point in the economic cycle, for stocks to move materially higher, we need inflation to increase to cause that relation trade, but we also need to be aware that this will bring us one step closer to the ultimate “bursting” of the recovery.
For more information on this topic, watch Redefining Retirement this Sunday at 5:30pm on Channel 2 as we discuss Sequence of Return Risk and how something completely outside of your control can determine whether you succeed or fail in retirement.