Financial Planning for April 2017

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What Is Reflation and How Does It Affect Investors?

What Is Reflation After four years of inflation rates just at or below 2 percent, many economists believe America has finally entered a period of reflation. Reflation is the turning point and first phase of economic growth toward increased inflation.

Much of the recent impetus comes from the new Trump Administration, supported by campaign promises for tax cuts, new jobs, increased investment in building the country’s infrastructure, and strong economic growth. Indeed, reflation trades have driven a large share of market volume since the Nov. 8 election results.

Reflation is characterized by a bump in both the prices of consumer goods and higher wages to pay for them. The economic life cycle that starts with reflation typically follows a certain pattern. First, when more jobs are introduced employers must compete for the best job candidates, so they begin to increase compensation packages. Higher wages mean those companies must increase their prices for the goods or services they produce. Higher prices mean the next phase has kicked in: inflation. When inflation rises, the Federal Reserve Bank steps in and raises interest rates, as it did most recently in March. Raising interest rates makes it more expensive to borrow money, which slows down growth and the rate of price increases.

Higher interest rates also can have an impact on investor portfolios. Specifically, when interest rates rise, the prices of existing bonds drop. That’s because new bonds are issued incorporating higher yields, so older bonds with lower yields lose value.

A retiree living on fixed income generated by a bond portfolio will continue to receive that income unabated until those bonds mature. However, many investors prefer to sell their older bonds in favor of those with higher yields. When they sell in anticipation of new issues on the horizon, this is called a reflation trade.

Reflation trades also are popular in the equity market. In fact, between Nov. 8 and March 1, the Dow Jones Industrial Average rose more than 15 percent on the heels of one of the longest running bull markets in history. While a substantial hike in yields could make equities less appealing, stocks generally benefit from higher growth during inflationary times. Commodity, bank, and value stocks tend to be reflationary winners.

However, given the bumps in the political process that Trump has encountered since taking office, the market may be starting to lose a bit of wind in its sales. In a 1996 speech, former Federal Reserve Board chairman Alan Greenspan famously observed similar false values when cautioning, “But how do we know when irrational exuberance has unduly escalated asset values…?”

In response to the recent market rally, one investment analyst warned that “the equity rally and in particular the rotation into value sectors post Trump’s election has been massive – the second-biggest such move in over 30 years… We believe this rotation amongst investors has moved too fast and too far.” While investor sentiment remains positive for now, Trump’s policies thus far lack detail and show signs of opposition, which could mean a long, uphill battle. If that’s the case, reflationary trades may require a long-term perspective to net expected gains.


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