Winners and losers now that the reflation trade is back. Who does well and who struggles

A robust economy, with earnings still strong but inflation sticky, creates a tricky narrative for active investors. To see the impact of higher inflation and higher interest rates on companies, just look at the earnings release for CarMax this morning. Earnings and revenue in its latest February quarter missed estimates and it pushed back its goal of selling 2 million cars by 2026 to sometime between 2026 and 2030. What did CarMax blame? “We believe vehicle affordability challenges continued to impact our fourth-quarter unit sales performance, with ongoing headwinds due to widespread inflationary pressures, higher interest rates, tightened lending standards and low consumer confidence,” a statement said. Overall, this is a very tough environment for small cap stocks, speculative technology (think Cathie Wood/ARK), REITs, and utilities. For example, higher rates are generally bad for REITs because REITs rely on debt financing. Rising rates increase borrowing costs, and higher borrowing costs reduce profit margins. But long-term, the effects can be more subtle. For example, if rates go up because economic growth is strong, REITs can benefit long-term. It's usually also bad for utilities, because when rates rise Treasury bonds become more attractive due to higher yields. Higher rates also mean increased borrowing costs for utilities, which carry a lot of debt because they use a lot of capital. If utilities can't pass on the higher costs, their shareholders suffer. Some sectors do well with rising rates The reflation trades means a newfound focus on cyclical stocks that perform best when the economy turns up, such as energy, materials and hospitality. The problem is, energy and materials stocks have already been rising due to higher oil and a still strong economy. Energy is the second-best performer among S & P sectors year to date, up 17%. Communication services, led by a big move in Meta , is the leader, up 18%. Other potential beneficiaries of higher rates with a strong economy are defensive stocks, which tend to be less interest rate-sensitive, such as Kroger or Walmart . Another potential beneficiary is insurance stocks. Life insurance companies, for example, take the premiums they get from customers and invest them in bonds. When rates go up, they get more yield from those bonds, which generates more investment income. Key is strong economy and continued job growth If that changes, in particular if the job market weakens significantly and we still have inflation higher than desirable, that will be stagflation, and that will be a much bigger problem for the markets. The key is that the economy has to stay strong, which will help prop up earnings. Earnings have remained stable on the strong economy. First-quarter estimates have been steady in the past few weeks, with the S & P 500 expected to see gains of 5%, according to LSEG, and full-year growth in 2024 up 9.8%, little changed from the 11% gain expected on Jan. 1. All of this changes if the economy, particularly jobs, turns south. Job growth contracting alongside sticky inflation means “stagflation,” and if the market comes to believe that is a likely scenario, forget it. The S & P 500, which closed Wednesday at 5,160, will be in the mid-4,000s very quickly.