A factor play on inflation

With inflation on the rise it’s about time to dust off the inflation playbook. We investigate the impact inflation has had on the Value, Momentum and Quality factors historically and how investors may want to approach their factor exposures.

The re-opening of the global economy, as well as favorable base effects resulting from the Covid-19 induced lockdowns, have led to a prompt and meaningful rise in consumer prices. The US core consumer price index (CPI) rose 3.0% through the 12 months to April, marking the sharpest increase since 1995.

As a result, fears of sustained elevated inflation levels continue to roil investor sentiment, also reflected in significantly higher levels of Google search activity on inflation.                     

Figure 2 reviews the historical relationship between inflation and equity factor performance (for global developed markets covering a period from August 2001 until November 2020, to exclude the current period of rising inflation).

We consider four different inflation regimes: Inflation above or below trend paired with rising or falling inflation expectation. The first is identified by comparing the current US CPI level to the three-year moving average. For inflation expectations, we look at monthly changes in the US 10-year breakeven rate.

Periods of below trend and rising inflation tend to favour Value with pro-cyclical metrics, such as book yield or gross profit yield, performing best. When transitioning into an established / above trend inflation regime, cash-based Value factors, such as cash flow yield, outperform other Value metrics.

This is in line with the general concept that Value tends to show strong performance during economic recoveries, which is naturally when inflation expectations return. The idea is that rising inflation should also increase discount rates, making growth stocks, with projected earnings in the more distant future, relatively less attractive than value stocks.

Conversely, Momentum, which is usually negatively correlated to Value, performs worst in periods of below average but rising inflation. This suggests that such periods are characterized by sudden market rotations and disruptions to established trends that have adverse effects on the Momentum factor.

Yet, if inflation overshoots and we move into an above average inflation regime, momentum strategies show their strengths again.

Quality, on the other hand, usually delivers the strongest returns in periods of falling inflation expectations, which often coincide with a slowdown in economic momentum. In such market regimes, Value tends to suffer the most.

Conclusion

Our analysis highlights that investors tend to favor attractively valued stocks during periods of rising inflation expectations. This is because such an environment often implies higher-than-usual economic growth prospects, which support economically sensitive, ‘riskier’ value stocks.

With perfect inflation foresight, in our view some investors may wish to tactically shift factor exposures to take advantage of the interaction between inflation and factor returns. However, timing macroeconomic regimes is arguably as difficult as timing markets. 

Thus, with average inflation foresight, we believe most investors are better off diversifying their factor exposure to deliver meaningful performance in various inflation regimes.