The Reflation Trade Portfolio

By Matthew Hougan

Earlier Thursday morning, I was supposed to take part in a discussion on CNBC about how to use ETFs to build a "reflation portfolio."

We had technological difficulties in Maine, however, and couldn't get the satellite hookup going in time.

Even so, I thought it might be interesting to share the portfolio we were going to discuss. It brings up both an important as well as an interesting topic.

According to Wikipedia, "Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country's output."

Reflation is not necessarily good or bad, of course. The response from the Fed, the Treasury and Congress over the past few quarters probably saved us from a more crushing recession/potential depression.

But the challenging part comes next. Can the Federal Reserve and the Treasury drain money out of the system just right so that they don't: 1) stunt the recovery; and 2) create runaway inflation?

Color me skeptical. It seems like the "thread-the-needle" or "goldilocks" scenario is the least likely outcome. Far more likely is that political pressure (and natural optimism) will force the government to leave its foot on the pedal for too long, goosing the economy into an artificially strong recovery ... with a payoff coming through a substantial uptick in inflation down the road.

With that in mind, CNBC asked me to pull together a list of seven or eight ETFs that stand to benefit from reflationary trends. Here's what I came up with:

Reflation Portfolio/Ideas
ETF	Ticker	Weight
Equity (50%)
Vanguard Emerging Markets	VWO	20%
Vanguard FTSE All-World Ex-US Small Cap	VSS	10%
iShares Global Materials	MXI	10%
iShares MSCI Brazil	EWZ	5%
SPDR China ETF	GXC	5%
Commodities (20%)
SPDR Gold Shares	GLD	20%
Fixed Income and Currency (30%)
SPDR International TIPS	WIP	20%
WisdomTree Dreyfus Emerging Market Currencies	CEW	10%

There are a half dozen other ideas I could have mentioned: the iShares TIP ETF (TIP); the Vanguard Materials (VAW); the Market Vectors Hard Assets Producers (HAP); the Rydex CurrencyShares ... etc.

Tim Middleton, MSN Moneycentral columnist, did appear on the segment. He added a nice idea in the ProShares UltraShort 20+ Year Treasury ETF (TBT), which delivers -200% of the daily return of 20-year Treasury futures.

As with any "geared" ETF, you have to monitor long-term performance (as we examined in our recent webinar). But it is an interesting play on the reflation idea.

The general outlines of how a reflation portfolio would look are clear. On the equity end, it would focus exclusively overseas to benefit from a falling dollar, and put a particular concentration in emerging markets, which have been leading the economic recovery. It would also focus on materials and materials-heavy economies, such as Brazil.

Broadening out that view, my own "reflation model portfolio" has a strong allocation to gold. While I think gold faces headwinds in the short term, more traction over time for inflation should be good news to bullion investors.

I debated adding a commodity futures ETF, such as the PowerShares DB Commodity Index Fund (DBC). But the truth is that broad-based commodities did not perform particularly well during the inflationary period in the 1970s. Oil did well, gold did well, but ags and even industrial metals barely kept pace with inflation.

Turning to fixed income and currencies, I included allocations to international TIPS (WIP) and the new WisdomTree emerging markets currencies fund (CEW); the latter provides exposure to 11 different emerging market currencies. Emerging market currencies have rallied strongly since the March 9 lows, and the macro factors support their continued strength.

I don't think this should be 100% (or even 50% or 25%) of someone's portfolio. I don't own all these funds myself; my portfolio, as most people know, is boring, long-term focused and ultra-low-cost.

But it does show how investors can use ETFs to make very specific bets ... choices they could not have taken advantage of just a few years ago ... to hedge against various economic worries they may have.

If you had tried to buy foreign inflation-protected bonds a few years ago, for instance, most people would have laughed at you. Now you can do it from an E*Trade account for $9.99 and a 50 basis point (0.50%) annual expense ratio.

And that---if you're worried about inflation and a depreciating dollar—is a good thing.

[Editor's Note: An earlier version of this article had the incorrect ticker for the SPDR China ETF. The correct ticker is GXC.]

Original post

Comments

[RiskReturnO...:]

DBA has been less volatile lately than materials, oil, or gold. Overall trend is up, momentum & volume increasing, and just cleared an important resistance of $27 with decisive volume. Looks bullish to me at least in the medium term; next stop is $30 to fill the pre-Lehman gap.

Perhaps in the 1970's, you didn't have growth in China and India middle classes ... this time, you can count on the demand to be strong, while the falling dollar / reflation trade simply acts as a catalyst.

May 22 03:40 PM

[Mistrofan:]

Reflation? You gotta be kidding me. If you call "reflation" the run of money for USD to any other asset class then I can understand. Otherwise - by all means - we are and will be in DEFLATION!!!

May 22 07:08 PM

[Greg Weston:]

I disagree with general buying of emerging market currencies. In times of geo-economic crisis, they have generally performed much worse than developed economy currencies.

In developed economies, there is a more of an economic cushion during downturns and a higher degree of political stability, so monetary policymakers can avoid the temptation of engaging in competitive devaluations with other economies.

Another issue with emerging market currencies is who are your counter-parties? Will they still be solvent and ready to pay you and other people who shorted the dollar if there is a sharp drop in the dollar? Perhaps not.

May 23 01:35 AM

[mangy cat:]

weston- "another issue with emerging market currencies is who are your counter-parties? Will they still be solvent and ready to pay you"

yep, but the problem is much nearer home
still no data on cew holdings, but quote:
"the fund utilizes investments in high-quality u.s. money market investments and forward currency contracts to achieve a risk-return exposure that is economically similar to money market
instruments denominated in the specified emerging currencies"

judging by fact sheets on individual currency etfs (cyb, szr, brl, etc) the "high-quality u.s. money market investments" it holds are likely to be
"citi triparty repos" and others with shittybank and freddy (kruger) mac

houston, we have a problem
and it ain't at the central banks in ankara, beijing and pretoria
it's much closer home at "high-quality" u.s. financial institutions

May 23 11:49 AM

[mlyn:]

One has to be prudent in defining "emerging market" curriencies. Brazil and China have an agreement to trade with one another in their own "emerging market" currencies--in other words, avoiding the use of US dollar. Resource countries like Brazil, Canada, Australia can support their currencies.

May 23 12:51 PM

[D. McHattie:]

"It seems like the "thread-the-needle" or "goldilocks" scenario is the least likely outcome."

No kidding. Especially given the outsize proportion of owner's equivalent rent in the calculation of our inflation indices. Rents, home prices and owner's equivalent rents are falling and will skew our inflation measurements, making us think that inflation is moderate when, really, in everything but housing inflation is totally out of control.

Bernanke is definitely going to err on the side of inflation.

My reflation etfs would be GDX, PBW (or GEX) and NLR (do you realize how many nuclear reactors are in production?).

May 23 05:42 PM

[Analyste de...:]

>I don't think this should be 100% (or even 50% or 25%) of someone's portfolio.<

Agreed, not ALL of one's portfolio but perhaps 50% (against your core 50%) in a 70/30 portfolio monitored quarterly. Nothing wildly exotic here, btw.

Is VWO plus EWC & GXC somewhat redundant? (China & Brazil are the Top Countries held by VWO, 25%.)

May 23 06:31 PM

[Brian McM:]

Matt
Good concept...I would suggest that the world is a bit different now than the 1970s. While I agree the reflation idea is similar at a macro level, there are many significant differences. Because Chindia has such a large land mass and population, the demand for industrial and construction materials will be much larger than the 70s. So, copper, steel, cement, etc are likely to have significant excess demand. Same for ag commodities. Japan was the big developing market story of the 70s, but with only 100M people and a small land mass. Japan never changed its diet to Western style grains and protein, so placed little demand on wheat, beef, chicken, pork or sugar.

But China and India both aspire to Western style diets and amenities. We will see substantial excess demand in Materials and Ag the next 20 years on average. So, DBA, FXC, BHP, IYM, XLM, should all be added to the mix.

May 23 08:36 PM

[Jake2:]

This post has content! Thank you very much.

May 24 03:03 AM

[Chickenpookie:]

This economy is going nowhere without me.

May 24 02:42 PM

[Charles Pet...:]

Having 10% direct exposure to materials and 20% direct exposure to gold (unless I am missing something) seems to be a heavy overweight of gold relative to the rest of the commodities. Any reason for this? Why be that heavily in gold when it has significantly outperformed the other commodities recently. Haven't you missed part of if not all of the boat?

May 25 10:52 AM

[nathanredondo:]

I think this portfolio is a little distorted and not fully leveraging the potential upside in certain sectors . For instance GDX is completely absent, as is DBA.

Personally, I try to avoid ETFs for precious metals in favor of actual bullion- if you are going to get nailed on the collectible tax you might as well pay the extra premium and get the real thing and avoid the rollover costs. Further, I'm not all that optimistic about our near term prospects (perhaps I've been reading too much of Tyler Durden's posts) so you'll notice significant short positions in finance and CRE. I have also included in here some "pseudo-ETFs" such as closed end funds, but overall you can see my commodity exposure:

CEF (gold & silver bullion) 43%
GTU (gold bullion) 15%
DBA (wheat, soybeans, corn) 10%
FAX (Australian and asian bonds, pays a monthly dividend) 10%
FAZ (3x short financials) 3%
TBT (2x short treasuries) 13%
SRS (3x short CRE) 6%

May 25 01:42 PM