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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inflationary pressures on stock

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 Federal Reserve’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 expected to decline to 2-3% this year, and by 2025, the headline consumer price index (CPI) rate in the US is likely to realign closely with the central bank’s target of 2%. This should pave the 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?

How do equity sectors do under different inflation regimes?

We have divided the equity sectors into defensives and cyclicals based on their sensitivity to the overall market. Chart 1 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. With the exception of communication services, which seem to do poorly in all inflation environments.

Charts 1 and 2: Performance of equity sectors vs. overall market in different inflation regimes

Chart 1 & 2 :performance of equity sector vs. overal market in different inflation regimes

At the same time, some of the cyclical sectors such as energy and financials tend to do well when inflation is high (chart 2). 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 3). Both minimum volatility and high dividend stocks have larger exposure towards defensive sectors. Meanwhile, the high dividend yield and value indices have a larger concentration of companies in the energy sector, which benefit from a rising inflation environment.

Charts 3 and 4: Performance of equity styles vs. overall market in different inflation regimes 

Chart 3 &4 :performance of equity styles vs. overall market in different inflation regies

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 by an increase in the concentration of tech stocks, which tend to do well when interest rates are cut.

On the more cyclical styles, growth and quality typically outperform when inflation is low (chart 4). Both sectors have a high weighting towards tech. However, 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 having 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. 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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