- The recent surge in inflation has led investors to re-evaluate risks and opportunities in equity portfolios. To do so, investors may wish to look not just at inflation, but at scenarios for economic growth.
- We evaluate the performance of the MSCI World Factor and Sector Indexes conditioned on high inflation and varying growth environments since the 1970s.
- In high-inflation/-growth scenarios, value, quality, momentum, IT, materials and financials outperformed. In stagflation, it was quality, momentum, minimum volatility, health care, consumer staples, utilities and energy.
Whether it’s driven by fiscal and monetary stimulus, deglobalization, decarbonization or an overheating economy, higher inflation could have a profound impact on style-factor and sector performance. We investigate this impact by considering two potential economic-growth regimes, to get a fuller picture for equity investors.
Specifically, we focus on: stagflation (rising inflation, slower economic growth) and “heating up” (rising inflation, higher economic growth). Our analysis showed that, while factors such as quality and momentum have “worked” in both environments, we saw important delineation across style-factor and sector indexes.
Inflation is the hottest it’s been since the ’90s
Inflation has risen steadily since the end of 2020. As of November 2021, the consumer price index (CPI) for all items in Organization for Economic Cooperation and Development countries (a proxy for global inflation) stood at 5.85% — a level last observed in June 1996. Previous MSCI research focused on hedging inflation using commodity-focused stocks showed that inflation was driven not only by a sharp rise in oil prices (i.e., energy), but by core components. Whether the current wave of inflation is transitory or not, it remains important to understand the behavior of equity-market segments across different macroeconomic regimes.
How consumer prices have evolved over decades
Data from December 1975 to October 2021. “OECD Inflation” is the consumer price index of the Organization for Economic Cooperation and Development economies. “OECD Inflation [3m-36m]” is the difference in short- and long-term moving averages of inflation, where positive values indicate rising inflation. Source: OECD
Inflation’s impact on factor and sector indexes
Against this long backdrop, we looked at the relative performance of the MSCI World Factor and Sector Indexes during periods of rising and falling inflation, defining the two categories by the sign of the past-3-month-minus-past-36-month-average of all-item CPI for OECD countries.1 From December 1975 to October 2021, the MSCI World Momentum and MSCI World Quality Indexes outperformed during rising-inflation regimes, with 34 basis points (bps) and 23 bps of monthly excess returns, respectively, versus the broad-market MSCI World Index.
Quality’s outperformance may stem from the fact that firms with high profitability and low leverage were typically better positioned to pass on rising costs to the end consumer. Interestingly, the MSCI World Momentum Index performed well in periods when inflation was rising and when it was falling, which is not too surprising, as the momentum factor is not derived from financial-statement information, but exploits performance rotation of other factors and sectors.
Overall, the performance spread across sector indexes was larger than it was for factor indexes. When we slice the investment universe by Global Industry Classification Standard (GICS®)2 sectors, those that benefited most in times of rising inflation were defensive sectors such as health care, consumer staples and energy. Information technology (IT) was the only other sector with positive excess returns during rising inflation, and it performed even better in falling-inflation environments.
Active returns were conditional on inflation regimes
Monthly excess returns over the MSCI World Index from December 1975 to October 2021.
Accounting for economic-growth expectations
The OECD’s composite leading indicator, widely regarded as the barometer for economic growth, rose sharply since May 2020 and only showed signs of stabilizing in October 2021. Additionally, analyst expectations for earnings remained strong in 2021. We saw that the short-term forward earnings per share (EPS) of the MSCI World Index, stood at a healthy level of around 10%, as of October 2021, having normalized from an unprecedented nearly 25% earlier in the year.3 In other words, it appears analysts expect corporate earnings to continue to grow over 2022, which could be driven, in part, by an expectation of continued demand as economies open further.
Economic and analyst-projected-earnings growth over time
Data from June 2003 to October 2021. Source: OECD, MSCI
The exhibit below shows average monthly active returns of factor and sector indexes relative to the MSCI World Index accounting for economic growth, as well as inflation in stagflation (x-axis) and heating-up (y-axis) periods. The MSCI World Momentum (+49 bps stagflation, +11 bps heating up) and MSCI World Quality (+34 bps, +6 bps) Indexes outperformed in both regimes (top-right quadrant).4 This may interest investors who expect inflation to rise, but have no strong conviction on economic growth.
For those who do have a view on economic growth, we saw interesting nuances for value and minimum-volatility. The MSCI World Enhanced Value Index (-14 bps, +11 bps) underperformed in stagflation and benefited from heating-up. Why might that be? Value firms’ earnings have historically followed economic cycles. Such companies often had a higher proportion of fixed assets and costs compared to growth firms, and tended to suffer more in economic downturns and perform better when economic growth picked up. In contrast, the MSCI World Minimum Volatility Index (+35 bps, -42 bps) has, on average, outperformed in stagflation periods. It was also in line with expectations as investors have tended to favor defensive strategies in risk-off environments caused by slowing economic growth.
Unlike factor indexes, no sector index performed well in both scenarios, indicating sector performance was driven more by economic growth (CPI) than inflation. The defensive sectors that performed well in rising inflation, on average, did so during periods of slowing growth, in line with their defensive bias. Similarly, the other sector that did well in periods of rising inflation, IT, did so in rising-growth periods.
Active returns in rising inflation: stagflation vs. heating up
Data from December 1975 to October 2021. Monthly excess returns over MSCI World index.
Too hot to handle?
Factor and sector characteristics have determined, to some extent, the ability to hedge inflation in different growth scenarios. Within factors, minimum volatility and enhanced value have outperformed the broad market in stagflation and heating-up environments, respectively, while momentum and quality factors outperformed in both.5 Among sectors, health care has done favorably in stagflation, and IT in heating-up, environments. MSCI will continue to monitor performance dynamics in various macro regimes and extend the analysis to other asset classes, as the inflation story evolves.
1The analysis period contained 169 months of rising inflation and 382 months of falling inflation. Over the sample period, the sign was negative on average (long-term inflation decline), but has captured inflation spikes, including the recent one in 2021. Due to data unavailability, the MSCI Minimum Volatility Index history prior to May 1988 was replaced with the MSCI Risk Weighted Index.
2GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.
3Short-term EPS data is available starting in 2003.
4We used monthly change in CPI to proxy rising/falling growth. We limited the analysis periods to rising-inflation regimes, splitting 167 months of rising inflation into two parts: 102 months of stagflation and 67 months of heating up.
5The analysis presents an average picture based on a long history (> 40 years) of index returns, which includes the 1970s and 1980s, which were characterized by significantly higher levels of inflation compared to more recent times.