Benjamin R. Nastou, CFA
Jeffrey D. Morrison, CFA
Institutional Portfolio Manager
Quantitative Research Associate
Jed Stocks, CFA
After remaining at low levels for many years, inflation has begun to rise significantly in the United States. US CPI has risen by more than 7%, the largest year-over-year increase since 1990. Inflation now appears less transient than many economists expected, and investors are wondering what assets may protect their portfolios if high and rising inflation persists. Historic episodes of inflation have been accompanied by falling multiples and margins and rising interest rates and hence challenged returns for both stocks and bonds. However, we believe there are tilts that investors can make in their portfolios to help cushion inflation’s adverse effects.
In this paper we discuss how equity styles or factors have performed over different inflation environments. To obtain a long history and to use data that practitioners are familiar with, we utilize Ken French’s factors: size,
value, profitability, investment and momentum. In 1992 Dr. French along with Eugene Fama created the model that identified the three primary factors that predict market returns. In 2014 they updated their research to
include 5 factors. Their formulas have been the foundation upon which today’s thinking on asset allocation, portfolio construction and performance analysis has been built. While the equity market risk premium is an
important component of French’s model, our analysis does not focus on it significantly, except to acknowledge that historically, real returns of equities have been doubly challenged during periods of high inflation, typically due to increased business risk and higher discounting rates.
Inflation regimes included in our analysis
While inflation hasn’t been this high for a long time, there have been multiple episodes of high inflation throughout history that we can learn from. Typically, episodes of rising inflation were associated with major
wars. High inflation has also accompanied the end of the Bretton Woods currency regime during the 1970s.
Exhibit 1 below illustrates these significant historical episodes of rising inflation as well as the deflationary period of the 1930s.
While sudden, unexpected spikes in inflation may be alarming, the real pain felt by investors comes from prolonged periods of high inflation. In an effort to understand these impacts on different equity factors, we looked at three of the periods we identify in Exhibit 1: World War II and the decade of the 1940s, the end of Bretton Woods system in the 1970s and as a counterexample, the deflationary 1930s, which saw a dramatic drop
in prices and output as a result of the Great Depression. Exhibit 2 shows how each of the factors performed during these periods. It should be noted that in our analysis the data on small caps, value, and momentum starts in the 1920s and the data on profitability and investment starts in the 1960s.
The results are as follows:
Small vs. Big: The results are mixed. Small caps outperformed large caps in the inflationary environments of the 1940s and 1970s. However, small caps enjoyed their strongest outperformance versus large caps during the 1930s, which were deflationary, so it is not completely clear whether there is any relationship between the smallcap premium and inflation.
Value: Cheap stocks outperformed expensive stocks in both the 1940s and the 1970s. The value premium experienced relatively weak performance during the 1930s deflationary period, further supporting the thesis that
value may outperform during inflationary periods.
Momentum: Momentum as a factor (buying strong performers and selling weak performers) did very well during the 1940s and the 1970s and terribly during the 1930s. Momentum often enjoys strong returns but periodically suffers the severe crashes that tend to accompany deflationary episodes. In addition, inflation episodes tend to be prolonged, which may benefit momentum strategies as investors jump while the trend persists.
Profitability: This factor is often used as a proxy for quality. Data are not available from the 1930s and the 1940s and results were fairly flat for the 1970s. Part of the flattish performance of the 1970s could have been driven by the Nifty 50 bubble in high-quality stocks which may have served as a headwind to profitability in the 1970s.
Investment: The investment factor measures the outperformance in companies that have slower growth in assets and is about 70% correlated with value. Data are not available until the 1960s, but during the inflationary period of the 1970s, investment does well, similar to value.
Exhibit 3 shows how these factors performed during the 1970s. It indicates that the outperformance of value, momentum, and investment accelerated as inflation rose meaningfully in the second half of the decade.
Overall, these findings suggest that value and momentum seem to be the factors with the strongest performance during periods of inflation. Most quantitative equity managers typically have significant exposure to both value and momentum factors, and the relationship between these two factors and inflation has created a headwind for quantitative investors during the past decade of very low inflation. If the increased inflation that we have experienced recently continues, this headwind could become a tailwind for quantitative investors.
Will this pattern repeat itself?
Determining which factors will perform well is not as simple as asking whether inflation will be high or not. There are many other drivers at play, including starting real interest rates, growth and starting levels of valuation. For example, the argument is sometimes made that prior periods of inflation are not useful examples of our current environment, as the US Federal Reserve will not raise interest rates materially and real interest rates will stay low or fall. Historical observations do not line up with this argument as changes in interest rates tend to trail inflation. In the 1970s, interest rates did not rise as fast as inflation and real interest rates fell. Likewise, in the 1980s when inflation fell significantly, interest rates did not keep up and real interest rates moved higher. This can be seen in Exhibit 4, which shows inflation, real GDP growth and real yields over the 20 years ended December 1989.
Given these historical relationships, how should one think about investing in 2022? Over the past 12 months, we’ve seen inflation and interest rate moves that both point to a decelerating economic and earnings outlook.
While there is a wide range of potential outcomes for the next year, we see two tail scenarios becoming more likely.
Stagflation: In this scenario, inflation remains high and the Fed follows through on its goal to control inflation and hikes rates aggressively over the next year. Tighter monetary policy would likely lead to higher bond yields, but historically tightening is also associated with slower economic growth and higher risk of recession. This may favor growth and profitability, as these companies would have a larger cushion to withstand an economic slowdown. Caution is warranted however, as valuations on these stocks are elevated and rising interest rates typically coincide
with value outperformance. Higher inflation throughout the year may also be supportive of momentum, which has done well historically in periods of high inflation.
Disinflation: In this scenario, we see is a midcycle reset where growth slows, but inflation also retreats. Fed rate hikes would be minimal or possibly not needed at all and the risk of recession would be lower than the stagflation scenario. Slower growth and less Fed tightening would likely lead to lower bond yields in general. With slower growth and lower interest rates, this scenario could be favorable for growth and profitability, though valuations on these stocks remain elevated. Reminiscent of a late cycle environment, we may also see relative value performance challenged.
With inflation at longtime highs and uncertainty over exactly how the Fed will respond, it is difficult to predict which scenario will play out. Both give off mixed signals as to which factors would perform best. Given this, a
diversified approach to factor positioning may be warranted at this point. We believe that a portfolio invested in higher-quality value stocks along with quality compounders (companies with high profitability and returns
on invested capital) that can be bought at a reasonable price would be a solid foundation of a resilient portfolio. Momentum strategies have fared well over the long run, particularly in periods of high inflation, and could offer additional diversification helpful in positioning in either scenario. Combining exposures to multiple factors may help dampen the impact of a drawdown and increase the potential for outperformance in a recovery.
Source: MFS White Paper March 2022