Why it may still be early days for the stock-market reflation trade

Why it may still be early days for the stock-market reflation trade

The reflation trade — a bet that assets that benefit from a post-pandemic surge in growth and inflation will outperform their traditionally safer counterparts — might not be as popular as many believe, say analysts at Jefferies.

If so, the trade may have plenty of room to run, they argued, in a weekend note.

“The recent price action, earnings revisions and economic stats are dwarfed when compared with the strength seen in prior cycles,” they wrote. “We’d argue that if you are judging by these numbers, the consensus call is actually skepticism.”

Since last March, when the bear market triggered by the COVID-19 pandemic bottomed, value stocks have outperformed growth stocks by 10%, they noted, while a bet that the small-cap Russell 2000

would beat the tech-heavy Nasdaq-100

trade is up 20%. Value stocks are shares that are viewed as undervalued against metrics like price-to-earnings or book value; growth stocks are shares of companies that are expected to see earnings and revenue grow faster than their peers. Value typically outperforms growth as economies exit recessions and transition to growth.

“Coming out of the dotcom bubble, these trades posted +120% and +260% trough to peak, respectively,” they said.

Stocks overall edged lower on Monday, with the S&P 500

off 0.5% and Dow Jones Industrial Average

down around 117 points, or 0.3%, after ending Friday at records. The tech-heavy Nasdaq Composite

was off 1.1%.

Meanwhile, the sectors expected to benefit from the reflation trade, such as financials, materials, industrials and energy, remain below the pre-COVID relative level, the analysts said, despite the highest inflation expectations in several years (see chart below).


A pullback by Treasury yields
after hitting 14-month highs in part due to rising inflation expectations, has allowed some of the initial pandemic highfliers recoup some lost ground relative to beneficiaries of the reopening trade, but Jefferies is skeptical that can last.

“A short-term pause in the massive backup in rates is certainly good for tech shares, but how long can it last for and what will happen once cyclical sector [earnings-per-share] growth is leaving tech in the dust?” they wrote.

Beyond that, a key reason the reflation trade is “understood but not working” may have to do with the magnitude of earnings revisions for the next fiscal year (FY2 in the chart below) so far in 2021


Earnings revisions refers to changes in analyst estimates for corporate earnings in a quarter.

When ranked according to the magnitude of revisions in the year to date, most of the reflation sectors are outperforming the S&P 500, the analysts said. “However, industrials has been lagging, and tech has seen strong revision momentum so far. This will be critical to watch over the next several weeks as 1Q earnings season could increase the divergence for cyclical sectors vs. the pack.”

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