What reflation means for
your portfolio

May 24, 2017
By BlackRock

Reflation has arrived — and it has meaningful implications for investors. But what exactly is it?

More than inflation, although it plays an important part, reflation is “a virtuous cycle of higher economic growth, income and prices,” according to Richard Turnill, Global Chief Investment Strategist with the BlackRock Investment Institute (BII).

The BII has identified reflation as a defining market theme of 2017 — one to position portfolios around.

Reflation and stocks pair well. But Treasuries and other government bonds still play a key role in helping to stabilize portfolios when downside surprises upset equities.

U.S. roots, deeper international potential

Reflation accelerated in the second half of 2016 and now looks to have moved into a phase of sustained growth.

Initially deemed a U.S. story, Mr. Turnill and the BII suggest the reflation effect is widening and, in fact, may offer greater surprises — and opportunities — beyond U.S. borders.

“These surprises are already evident in both economic growth and inflation. The latter, once seen as a U.S. phenomenon, has raised more eyebrows in Europe and Japan, where deflation risks have peaked and there have been recent signs of inflationary pressures returning,” he says, noting that wholesale prices in China have also shot up after sliding for five straight years.

The opportunity is coming through in companies’ earnings expectations.

An awakening of inflation
U.S., eurozone and UK trimmed mean inflation rates, 2003–2017

An awakening of inflation

Investment implications

“Earnings momentum is particularly strong in Japan and emerging markets, while solid in Europe. This supports our preference for stocks in those regions,” says Mr. Turnill.

The BII is less sanguine on U.S. stocks, citing the need to balance strong earnings momentum with high valuations and policy uncertainty in Washington.

Just as reflation is bestowing benefits for stocks, it is creating challenges for bonds.

Bond markets experienced a profound shift at the end of 2016 as they recalibrated to accommodate higher inflation expectations and an improving economic outlook. Yields rose, and prices fell — a painful reminder that even seemingly “safe” positions such as high-quality Treasuries and municipal bonds can suffer amid rising rates.

After some 35 years of falling yields and rising bond prices, “strengthening reflation reinforces our view that we have seen the bottom in bond yields globally,” says Mr. Turnill.

While this means government bonds may be challenged, the BII acknowledges their important role in diversifying equity risk within an investment portfolio.

“Stocks have historically done well in reflationary environments because they are geared to global growth,” Mr. Turnill says. “While the expectation of higher yields underpins our preference for equities over bonds, U.S. Treasuries and similar government bonds still have a key role to play in helping stabilize portfolios when downside surprises roil stocks.”