Reflation: A Dominant Theme for 2011

The geopolitical events in Egypt had the potential to turn investors' attention back to concerns about the durability of global economic growth that prevailed last summer. Instead, investors appear to be less worried about growth retreating and are starting to differentiate their investing based on prospects for reflation and rising interest rates. What seemed to be a world locked into one unified global business cycle a year ago is becoming more and more decoupled as each market classified by size, country, and sector show differing reactions to the return of inflation and the rise in interest rates.

Stocks and bonds have followed different paths with the S&P 500 up 6% and the Barclays Aggregate Bond Index down 1% year-to-date. An improving growth outlook and the risk that rising food and energy prices will spread into other goods and services have pushed up long-term bond yields to the highest levels in almost a year.

The impact of rising interest rates can also be seen in smaller companies, which generally have a greater dependence upon favorable borrowing conditions, as they have underperformed their Large Cap peers this year after generally outperforming since the market low in March 2009.

When prices reflate, commodity producers are typically beneficiaries. Not surprisingly, the best performing sector of the stock market this year is Energy. This year's worst performing sector is Consumer Staples, where companies face the high cost of food and energy inflation as inputs to their products. Also, the most interest-rate-sensitive stock market sectors, Telecommunication Services and Utilities, are among the worst performers this year as rates have risen.

Emerging Markets have been underperforming developed markets this year for the first time in quite some time. Reflation has been more prevalent and problematic in the Emerging Markets. Rising inflation, mainly food and energy prices, have been spurring unrest in a number of emerging market countries such as Egypt, central bank rate hikes in countries such as China, and a booming economy in places like Brazil are pushing up interest rates. The MSCI Emerging Markets Index is down 5% this year, while the MSCI EAFE and S&P 500 Indexes that represent developed markets are up 4% and +6%, respectively.

Even within the Emerging Markets the reactions to the return of inflation have been different. The stock markets in those Emerging Market countries that benefit from rising prices (oil and food exporters) are faring well this year, such as Russia (+7%), Nigeria (+7%), and Iceland (+6%). While some Emerging Market commodity importers have suffered, including India (-15%) and Brazil (-5%).

The theme of reflation is defining the relative performance of all markets so far this year. We expect reflation to remain a key theme for all of 2011. This is a major change from 2010 and one that investors are more likely to be impacted by than the attention grabbing change in leadership in Egypt.

There will be much discussion in the coming days and weeks about who may become the new Egyptian president. However, as has been the case during transitions in Egypt over the past 60 years of military rule, the military is an institution that transcends the individual. Certainly, there will be a new president. But, just like The Who's Roger Daltrey sang, "Meet the new boss. Same as the old boss."

Readers Also Like:

>>5 Top Stocks for Market Rally of 2011

>>3 Gold Stocks With Potential

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.

« First ‹ Previous 1 2