Equity markets and the global reflation trade

What reflation is, how it has historically been manifested, and what it means for today’s equity markets.

Download the full report
February 25, 2021 | 12 minute read

For much of the past decade, the equity market narrative was dominated by the rise of large U.S. tech firms amid a world of slow growth and low interest rates. As the global economy enters a new expansion, a different market paradigm — the so‑called “reflation” trade — has come to the fore.

Key takeaways
  • The rally in global equities, which was initially led by resilient tech firms, has shifted since late 2020 to cyclical areas of the market.
  • Reflation dynamics have historically benefited cyclical stocks, which exhibit higher levels of operating leverage.
  • Markets have moved quickly to price in a better economic future; however, there is reason to believe the reflation trade has further room to run.
  • Outside the U.S., Europe and emerging markets offer interesting ways to get exposure to global reflation.

Following a dislocation remarkable for both its depth and transience, equity markets rapidly recovered from the depths of the COVID-19 crisis. Markets were vindicated in their view that the impact of the pandemic on company earnings would be sharp but fleeting, illustrated by the fact that in the U.S., Q4 S&P 500 EPS have eclipsed 2019 levels.1

“Recovery” may not be the appropriate word for markets anymore — indexes across the globe continue to hit new all-time highs. In the U.S., the S&P 500 and Russell 2000 are each more than 10% above pre-crisis highs, while emerging markets and Japanese equities have each broken above multidecade trading ranges.1 It would appear, for now at least, that global markets are pricing in robust economic growth for the foreseeable future.

No doubt, the future has begun to look brighter for economies across the globe. The IMF recently upgraded its 2021 global GDP growth estimate to 5.5%, which would be the strongest since 2007. The combination of unprecedented government aid, a vaccine-led reopening and pent-up demand is expected to lead to strong global growth and, potentially, higher inflation.2

Certainly, these dynamics have had a massive impact on equity market leadership. High-growth, stay-at-home stocks led the market out of the spring doldrums, but since the events of early November (i.e., the U.S. election and news of viable COVID vaccines), it has been cyclical, small-cap and value stocks that have led.

In many ways, this “reflation” trade is typical of an early-cycle environment. What is unique about the current situation is how quickly markets have moved to price in a brighter outlook. In this note, we put reflation in a historical context and identify the equity market sectors that have typically benefited. Then, we analyze the current environment and explain why, despite the seemingly unrelenting rally, we still see opportunity in today’s market.

  • Bloomberg Finance, L.P., as of February 19, 2021.

  • International Monetary Fund, as of January 26, 2021.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Andrew Korz, CFA

Executive Director, Investment Research

Search our site