Don’t Give Up on Economic Growth

In recent weeks, under the surface of cresting successive highs, major U.S. market indexes have experienced some striking reversals: Defensive stocks have outperformed cyclicals and large-capitalization names have beaten out small caps, while growth stocks have regained ground against value plays. In the meantime, long-term Treasury yields have eased, amid the bond market rebound from its tough first quarter.

Some might read these reversals as the beginning of the end of the so-called reflation trade, with its focus on investments that traditionally benefit from economic expansion, coupled with rising consumer prices. After all, investors could interpret resilient Treasury prices in the face of threatening inflation data as validating the secular stagnation of the previous business cycle, with a return to “lower for longer” rates and narrow, albeit solid, growth already underway. 

According to this narrative, current earnings expectations already price in much of the good news about the economic rebound and post-pandemic re-opening, calling for a more defensive, conservative investment approach, including a bullish outlook for bonds. We disagree and believe that a defensive shift for investment portfolios is premature. In our view, recent events represent a pause—not a reversal—in the reflation trade. 

The nature of the new business cycle offers the most forceful arguments for reflation and growth that could be much broader and stronger than the prior cycle. Fiscal spending, with its emphasis on infrastructure, would be inherently linked to greater “capital deepening,” in which capital per worker is increasing in the economy. And inflation—more than just transitory—would be accompanied by improving demographics and faster credit growth. The latter element should kick in after huge pent-up demand and excess savings are exhausted. 

Regarding interest rates, we see the recent, rapid move down in 10-year Treasury yields (from 1.74% to 1.58%) as technical rather than fundamental, with short-covering and defensive hedging playing major roles, as we enter earnings season. In fact, strong economic data have continued apace—as have inflation metrics. Seasonally adjusted retail sales for March rose 9.8% from February, and the latest year-over-year Producer Price Index reading was up 4.2%, its fastest pace in 47 years. Inflation numbers around used cars and new homes have also been compelling. 

We think investors could take advantage of the current pause in the reflation trade to rebalance their portfolios, and that the core of the reflation trade—toward cyclical and value factors—will prevail.

Our research suggests that value-investing tends to outperform growth-investing during above-average economic growth and rising inflationary expectations; we expect both conditions to persist in the new business cycle. With earnings revisions and a rebound in inflation expectations as catalysts, and with valuations so stretched, the focus will likely shift to growth at a reasonable price, also known as GARP. 

Investors should watch for growth indicators and inflation expectations, while continuing to refocus away from long duration and rate-sensitive sectors in both bonds and stocks, and toward pro-cyclical, non-U.S., short duration, value and quality.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 19, “The Reflation Trade is Not Over”. Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.