More than a mere question of style

Inflation is almost at its highest point in a generation. Many investors are therefore wondering what impact high rates of inflation will have on the financial markets and, therefore, on their portfolios over the longer term. Here, a glance at the past may be helpful. But first, let's look at the present.

Although it is not uncommon for inflation to occasionally increase during the business cycle, nevertheless there are some distinctive features in the current inflation cycle. The global supply chain had never before been interrupted so dramatically as it has been by the Covid-19 pandemic. In addition, the Russian invasion of Ukraine has disrupted the supply of energy, fertiliser and grain. Because these factors coincided, prices have increased more than they had for decades. The pandemic also caused far-reaching changes in the labour market. Wages increased, adding to inflation. That is the present. What can we learn from looking at the past?

Shares are not all the same

Historically during periods in which the economy was growing and inflation was moderate, equities performed relatively well. In the short term, share prices may fall when inflation is expected to increase, but over the long term, equities overall are considered a good hedge against inflation. But shares are not all the same. It pays to take a closer look at how inflation affects individual sectors. For example, the US economy, i.e. the economic area with the most robust inflation data: companies from sectors such as energy and basic commodities often hold or control physical assets, and may sell commoditybased products. Since the value of their assets and the price of their products increase in parallel with inflation, their share prices are positively correlated with inflation rates. In other words, their share prices generally increase as the pace of inflation picks up. By contrast, companies from sectors such as staple goods and utilities are negatively correlated with inflation rates. This is mainly because such companies consume raw materials, and therefore have to accept higher input prices. In turn, on average this negatively affects their profit margins and share prices.

If you take an even closer look, you will find the answer to the question of whether certain companies within a sector are harder hit by inflation than others. Which brings us to active portfolio management, the purpose of which is to identify potential winners whenever possible. Many companies can increase their prices and thereby pass higher costs on to their customers. These companies are precisely the ones active investors try to identify based on the sales trend and profit margins. They are looking for qualitatively high-value companies with high and stable profit margins that tend to perform better when inflation rates are high or increasing.

Style as protection against inflation?

Many investors want to beat the market on average with the help of style investing. Here, too, a glance at the past may be helpful. Research analysts from Allianz Global Investors’ Systematic Equity Team have examined how various known equity investment styles have performed during eight periods of high inflation in the USA since 1940.¹ Their finding: attractively valued equities, so-called value shares, have beaten the benchmark in six of the eight inflationary phases. Momentum equities, i.e., securities chosen for their performance over the previous 12 months, on average continued their track record and likewise beat the benchmark in six out of the eight periods. What is more: when inflation was high, these equities on average generated higher excess returns than during normal times. Companies with higher earnings or a more solid balance sheet, so-called quality equities, beat the benchmark in four of the six periods for which data were available.

Investors can draw four conclusions from the above. First, in the short term, share prices may fall when inflation is expected to increase, but overall, equities are considered a good hedge against inflation over the long term. Second, in the past, companies in the energy and basic commodity sectors have been positively correlated with inflation. As a result, the value of their assets and the prices for their products tend to increase along with inflation. Third, within the individual sectors, some companies are better positioned to increase their prices and pass the higher costs on to consumers. Active asset managers can try to identify such companies based on trends in sales figures and profit margins. Fourth, in the past, the value, momentum and quality investment styles have tended to perform above average during periods of high inflation rates.

Inflation itself? It is almost at its highest point in a generation. But investors can protect themselves with the right equity strategies.

¹ Henry Neville, Teun Draaisma, Ben Funnell, Campbell R. Harvey and Otto Van Hemert, 2021, “The Best Strategies for Inflationary Times”, May 2021 | Kenneth R. French, “Data Library”, mba tuck Dartmouth, 2022