Which areas of the equity market might perform best should inflationary pressures ease?
Investors may need to reassess how they position their portfolios if inflation falls back as expected over the course of this year and next
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The sharp fall in US inflation during 2023 raised hopes for aggressive interest rate cuts by the Federal Reserve (Fed). But since then, the market has gone from discounting between six to seven rate cuts to barely two.
With economic growth proving to be more resilient and inflation higher than expected, rate cut expectations have been dialled back. The Fed's chair, Jay Powell, recently said that it is taking 'longer than expected' for the central bank to achieve its inflation target of 2%.
That said, inflation is still expected to decline this year to 2-3% and by 2025 the headline CPI rate in the US is likely to return back very close to the central bank’s target of 2%. This should pave way for the first cut to occur later in 2024.
In a world where inflation is headed lower, how should investors position their portfolios in terms of equity sectors and styles?
What are the equity styles and sectors?
Before going into the analysis on how different inflation environments impact the performance of equity sectors and styles, table 1 provides a summary of different equity styles.
Here we show the beta to illustrate the sensitivity of the investment strategy towards the performance of the overall market. For instance, the more defensive equity styles including value and high dividend yield, or sectors such as utilities and health care (see tables 1 and 2), have a beta of less than one. These are the areas which tend to outperform when the market sells off.
In contrast, cyclical styles such as small caps or growth stocks, or sectors such as consumer discretionary and energy, are more sensitive to the performance of the broader market. Although the beta can change over time as seen by the energy sector, which has become less sensitive to the overall market over the past 12 months.
Sectors matter to the performance of equity styles
Earlier we mentioned that some equity styles have more defensive characteristics than others, and this is partly due to their sector composition. Table 3 gives a snapshot of the sector distribution of the different equity styles versus the overall market.
Equity styles, like minimum volatility and high dividend yield, which are more defensive in nature versus the overall market have a larger weighting towards sectors such as health care and consumer staples. In comparison, the growth style is higher beta and is dominated by the information technology (tech) sector.
But these sector exposures are dynamic and can vary over time. For example, compared to twenty years ago, the small cap style has increased its share of financial and real estate companies but reduced its exposure of tech and consumer discretionary sectors. Meanwhile, the momentum style’s exposure to tech has grown as it has been the sector with positive momentum in recent years.
Defining the inflation environment
There are several ways of looking at the relationship between the performance of various equity styles and the inflation environment. Here we have used the headline CPI rate, but we have also explored other inflation measures, such as the core CPI rate and consensus inflation expectations. The results from using the core CPI rate were generally similar but we found no meaningful relationship between the performance of different equity styles and inflation environment defined by consensus inflation expectations.
Chart 1 shows how we defined the inflation regimes based on different CPI intervals going back to the 1970s. We find that inflation generally spends an equal amount of time in each of the inflation regimes. The exception being periods of deflation, which we have excluded in our analysis given the rarity of occurrence.
How do equity sectors do under different inflation regimes?
We have divided the sectors into defensives and cyclicals based on their sensitivity to the overall market. Chart 2 shows that most of the defensive sectors outperform when inflation is high as they are more resilient to the increase in prices as consumers still need to buy necessities such as food and health care. The exception of communication services which seems to do poorly in all inflation environments.
At the same time, some of the cyclical sectors such as energy and financials tend to do well when inflation is high (chart 3). The energy sector's income depends on the prices of oil and gas, which is a key component of the headline CPI rate. Financial stocks tend to do well in a high inflation and interest rate environment as the net income earned by banks increase. The net interest income is the profit from lending at a higher rate over the interest paid to depositors.
In comparison, cyclicals such as tech and consumer discretionary generally outperform when inflation is low. This is because when inflation is low, interest rates tend to be low. Tech stocks are more sensitive to higher interest rates because they generate a sizeable proportion of their earnings in the future, so these future cash flows are being discounted at a higher rate. For the consumer discretionary sector, some of the stocks have significant exposure to tech to facilitate their business. At the same time, when inflation rises, consumers usually prioritise spending on essential items rather than on discretionary spending on goods and services.
How do equity styles do under different inflation regimes?
The more defensive equity styles tend to do better when inflation is high (chart 4). Both minimum volatility and high dividend stocks have larger exposure towards defensive sectors. Meanwhile, the high dividend yield and value indices have larger concentration of companies in the energy sector, which benefit from a rising inflation environment.
But the momentum style tends to perform well when inflation is low even though it is more defensive compared to the market. This might be because these stocks gain from the recovery in equities more broadly when inflation and rates are low. In recent times, the momentum style has also been impacted from an increase in the concentration of tech stocks, which tends to do well when interest rates are cut.
On the more cyclical styles, growth and quality typically outperform when inflation is low (chart 5). Both sectors have a high weighting towards tech. But the quality style does not have a clear result when inflation is high, unlike the growth stocks which perform poorly. This might be because the quality index is more invested in defensive sectors.
On the other hand, small caps act like the more defensive styles as they perform better when inflation is high rather than low. This is likely due to small caps have a higher weighting towards some defensive sectors and financials.
Conclusion
With US inflation at 3.5%, within the 3 to 5% range, the more defensive equity sectors and styles typically do well. Although cyclical sectors such as energy and financials also tend to outperform. Instead, growth, tech and consumer discretionary stocks usually struggle in this inflation environment. But these stocks did well over the past year as inflation declined from 5%, boosted by better earnings.
As inflation falls to 2-3% this year, past patterns suggest that the momentum style and tech stocks are likely to outperform.
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