The ravages caused by the Covid imposed lock downs has created a need for reflation. This is the manufacture of inflation by increasing the amount of money in circulation in an economy. Our economies are dependent on inflation to function effectively. Today governments are introducing packages to stimulate inflation. In particular the size of President Biden’s Covid relief bill is designed to kick-start the US economy after the Covid imposed lock downs.
What is reflation
Why it matters to your investments
How you protect yourself and earn from it
The cornerstone of economies today is the creation of money, or growth. With growth, you create jobs, which in turn creates wealth, which leads to greater prosperity. In turn this means a happier, more stable society. Without growth, jobs are lost and prices either hold steady or worse, fall.
Falling prices, means less demand, less demand means less spending. In turn this means less wealth, which leads to increased unhappiness. Governments the world over seek to avoid this kind of scenario, by encouraging growth through their management of economies. Growth leads to inflation.
Inflation is a by-product of growth. By imposing lock downs on their respective societies, governments stopped many businesses from trading, stopping growth in its tracks. This has also caused much hardship and also caused inflation to become negative.
To create inflation and support companies and individuals emerging out of lock downs, governments need to stimulate growth through re-inflating the economy. The UK has also adopted a similar policy to President Biden.
Reflation can lead to too much inflation being created! When a government introduces a stimulus package as big as President Biden’s, you have more money chasing the same amount of goods. A day-to-day example would be food inflation. As inflation is created, the price of your weekly shop will increase, i.e. you will spend more to receive the same amount of food. If you are getting pay rises at work, then this is not a problem, but if your wages are stagnant, your purchasing power (how much you get for your money) has decreased. You are in effect getting poorer.
This could also affect the so called ‘safer parts’ of your portfolio, specifically bonds. If reflation occurs, interest rates will likely rise. If interest rates rise, then this reduces the return from the bond coupon, as a result the bond price falls. This will lead to a fall in the value of your bonds.
If bond yields were to rise quickly (as bonds become unpopular), then the reasons for holding higher risk, dividend paying stocks reduces. This could lead to a sell off of major parts of your stock portfolio.
The current market rally is at risk if yields rise, as growth stocks benefit from interest rates being zero or low. This is due to the combination of lower finance costs, increasing profitability and the lack of yield available for investors elsewhere.
With these risks in mind, it may be sensible to introduce a margin of safety into your portfolio by buying inflation protected bonds.
If interest rates rise then banks benefit. They benefit as the higher interest rates means they can charge higher interest on mortgages and other banking products. This makes banking stocks the place to invest your money, as a sector rotation takes place. You will also benefit from the momentum investing such a rotation causes.
A change in momentum is an opportunity.
For those who do not want to take single stock risk, you can buy and hold some passive investments. Examples include the iShares S&P 500 Financials Sector ETF & iShares MSCI Europe Financials Sector ETF, which give you a foreign portfolio investment as well as one closer to home.
For those wanting lower risk and portfolio protection, then government bonds are advisable. This would include US Treasury Inflation-Protected Security (TIPS) and UK index-linked bonds. In both cases, the value of the bond and the coupon they pay is uplifted in line with inflation. This reduces inflation risk.
An entire generation has grown up without inflation and learnt to invest with quantative easing as a supporting hand. The need for inflation as a by-product of growth can cause problems to investors who do not understand what it is. Rampant inflation is also a problem, but deflation can be worse, just ask the Japanese.
The reflation programs which are being launched by governments as we speak are both a risk and an opportunity. With an understanding of what they are, and the possible side effects, you can ensure you benefit!