November 09, 2021
Inflation, and the fact that it has ratcheted up in recent months, would ordinarily be a source of worry for equity investors. Generally speaking, high inflation is often seen as a negative for stocks, in part because some investors believe that lower
expected earnings growth can put downward pressure on stock prices.
However, this era of COVID-19 is no ordinary time. In our view, the pandemic is largely responsible for many of the current economic conditions and problems ranging from the global supply chain to the US labor markets to inflation. So, like the Federal
Reserve, we see the recent uptick in both headline and core inflation as transitory and not permanent. And, although the US Consumer Price Index (CPI) reached 5.4% in both June and July 2021 after averaging below 2% for the last two years (source:
US Bureau of Labor Statistics), we believe talk of a return to the high, 8%-10% inflation of the 1970s and 1980s is overblown.
Headline and core inflation since the 1960s
Source: US Bureau of Labor Statistics.
Higher prices may offer opportunities
Still, just because something is unlikely doesn’t mean that it can’t influence the thinking of equity market participants. If a substantial minority of investors believe that inflation is likely to become more of a problem in the future, they may start
bidding up the prices of stocks that are expected to be less sensitive to inflationary pressures – in other words, whatever they view as potential hedges against inflation. These may include commodity producers and associated industries, as well as
banks and homebuilders. Conversely, some companies, such as consumer discretionary or technology, may be expected to do badly in inflationary conditions – those prices may go down.
This can create an opportunity for momentum investors in the first instance of inflation-hedged sectors, and for value investors in the second. For investment teams that are either growth or value, that means, in theory, both can do well if they make
the right sector choices. Either way, active equity managers may be able to take advantage of this.
Active management and inflation hedges
Active equity managers have the potential to outperform in a wide range of market contexts. Conditions of rising inflation may present opportunities for active managers who have the ability to make strategic choices, such as focusing on sectors that may
react favorably or poorly to inflationary conditions.
In recent months, some market participants have been looking back at conditions in the 1970s and 1980s to see how different sectors behaved during that era. We think that the world has changed so much in the past four decades that such efforts are likely
to be of rather limited usefulness. Instead, we prefer to look at how equities have behaved during the period when inflation rates have generally been low in numerical terms, but when inflation has sometimes been rising and sometimes falling. As the
graph above shows, since the start of 1990 inflation rates have rarely gone above 3% for a sustained period. Focusing on these later decades, in our view, is more likely to reflect how financial markets have rewarded or punished different sectors
as inflationary conditions have evolved.
Moreover, we think that dividing the world into “rising inflation” and “falling inflation” is too simplistic. Rather, we consider that investors are smart enough to distinguish between inflation that is rising, flat, or falling. We believe that if trailing
12-month inflation is not more than 0.3% above or below its level from a year ago, then investors will consider that inflation is roughly “flat” in the sense that prices are neither accelerating nor decelerating.
Over the period from January 1990 onward, using these definitions, inflation was “flat” in about 43% of months, “falling” in 31% of months, and with the remaining 26% of months considered “rising.” Splitting up the historical experience in this way should
help to clarify how markets reward or punish different sectors according to prevailing economic conditions. The following chart summarizes our findings for the Russell 3000® Index, and reports the median monthly active total return for each sector,
based on core inflation data from the Bureau of Labor Statistics as of September 2021. The analysis incorporates a one-month lag to reduce the likelihood that look-ahead bias is affecting the analysis. We would note that this is solely an examination
of past reaction to relative inflationary conditions and not a predictor of future performance.
Equity sectors (Russell 3000 Index) performance in various inflationary periods
Sources: inflation data from US Bureau of Labor Statistics; Russell 3000 sector data from FTSE Russell via FactSet.
The sector responses to different inflation conditions contain a few surprises. Moderate increases in inflation are often associated with an expanding economy, which would presumably make consumers feel more confident about the near-term outlook, and
could explain why the consumer discretionary and consumer staples sectors have been relatively strong performers. Similarly, economic expansion is likely to be favorable for credit providers, and this could explain why the financials sector has also
been among the beneficiaries from such conditions. Conversely, rising inflation seems to have been viewed negatively for information technology (IT), at least compared to this sector’s significantly strong performance when inflation has been roughly
flat. Finally, it seems clear that both energy and materials have not been very effective hedges against inflation, although both sectors have also generally delivered disappointing returns when inflation has been approximately flat.
Inflation not necessarily bad for all
If higher inflation or the threat of it materializes, many equity prices could react unfavorably. But it does not necessarily mean bad outcomes for all. By focusing on certain sectors, some investors who are more oriented to short-term outperformance
have the potential to benefit by jumping on the bandwagon. Meanwhile, those investors seeking long-term gains may be able to pick up bargains. For both groups, paying attention to inflation may potentially create investment opportunities, with active
management the potential catalyst.