Author Details

Mehdi Alighanbari

Mehdi Alighanbari

Executive Director, MSCI Research

Anshul Kamra

Anshul Kamra

Executive Director, MSCI Research

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Inflation Sensitivity and Equity Returns

  • The steep rise in inflation after decades of low inflation raises many questions for investors. We use stock-level inflation sensitivity to help answer some of these questions.
  • Investors’ attention to inflation and its impact on stock prices are used to mitigate some of the shortcomings of simple regression to calculate stock-level inflation sensitivity.
  • We measure sector and factor indexes’ exposure to inflation to better understand their behavior during high-inflation periods.

Inflation and the chatter around inflation have been rising since last year (as shown in the exhibit below) following years of relatively tame inflation. This macroeconomic shift is likely to have both a short- and long-term impact on asset prices and has raised many important questions for investors. The variation in the impact of inflation on prices is often more significant when we look across different asset classes (e.g., equities vs. commodities), and macroeconomic models often provide insight into asset-class sensitivities to inflation and other macroeconomic signals. Within each asset class, also, prices behave differently in response to inflation.

In this blog post, we focus on equities and what rising inflation means for different portfolios and investment strategies.

 

The rise of inflation and inflation sentiment

Depicts the rise of inflation, CPI components, Google Trends activity and media attention.

*All Items in U.S. city average (year-over-year change in %). **All items less food and energy in U.S. city average. ***Worldwide interest in inflation, via Google Trends. ****Media attention to inflation from MKT MediaStats.

 

Measuring inflation sensitivity

We first need to measure the sensitivity of companies’ stock prices to inflation. There are two main approaches:

Bottom-up: Thoroughly analyze each company’s business model. Comprehend factors such as price elasticity, regulatory effects across channels and market-share developments. This will help estimate sensitivity of a company’s earnings and ultimately its stock price to inflation and inflation change.

Top-down: Regressing stock returns on changes in inflation or a signal that indirectly represents changes in inflation, such as changes in commodity prices.

The bottom-up approach may provide a more accurate measure of inflation sensitivity, but it can be a rather prohibitive undertaking when the investment universe is large. The top-down approach is simpler and more feasible as the stock universe grows. The challenge, however, is that we have been in a low-inflation (and relatively stable) environment for decades, which means inflation signals have had little variation. A simple regression, therefore, may result in less meaningful estimates.

While inflation has been relatively suppressed over the past few decades, the market expectation of rising or falling inflation and corporate pricing power have varied more meaningfully, and stock prices have reacted to these inflationary sentiments.

 

Assessing portfolio inflation sensitivity with an inflation score

We use inflation-sensitivity estimates (provided by MKT MediaStats) in our analysis, which implements an enhanced top-down estimation approach.1 The sensitivities are calculated by regressing stock returns on several macroeconomic signals, including breakeven inflation and oil and gold prices, while incorporating inflation attention and sentiment derived from news articles. Rolling windows are used in the calculations to capture temporal variations in stock sensitivities to inflation. The final sensitivity is calculated as a score ranging from 1 to 10, with 1 representing the lowest historical performance in response to higher inflation and 10 signifying the best performers. The use of sentiment in the calculation aims to capture the stock-price behavior not only to the inflation itself, but to investors’ sentiments, views and inflation expectations.

We can aggregate the stock-level sensitivity data to estimate a portfolio or index’s potential sensitivity to inflation. The yellow diamonds below show the current sensitivity of the MSCI USA sector indexes to inflation relative to the MSCI USA Index.2 The energy sector is a clear outlier, which may stem from the outsized impact of energy prices on the recent rise in inflation. Other sectors with positive sensitivity are financials and materials, while communication services, information technology and utilities show negative sensitivity.

 

Inflation sensitivity of MSCI USA Index sectors

Charts the inflation sensitivity of sectors in the MSCI USA Index.

Data from November 1999 to June 2022

The sector sensitivities are mostly aligned with the long-term performance of the sector during high-inflation regimes.3 These sensitivities, however, have changed over time, reflecting their response to different inflationary periods. For instance, the current sensitivity may have been impacted by the more supply-driven nature of the current inflationary period, rather than the demand-driven inflation of the past.

While different sectors show varied levels of sensitivity to inflation, there are also large variations within each sector. We detail below the range of inflation for stocks within each sector. Except for energy, we can see that within each sector, there are stocks with a wide range of positive and negative sensitivities. This figure indicates that each sector has stocks with pricing power by way of industry structure, business model or growth.

 

How inflation sensitivity varied by sector

Shows how inflation sensitivity varied by the sectors of the MSCI USA Index.

Data as of June 30, 2022.

 

Factor sensitivity to inflation has changed over time

Factors’ current sensitivities to inflation (as shown in the exhibit below) are mostly aligned with the historical performance of these factors during past inflationary periods.4 Value and momentum, the two factors that show the most positive sensitivity to inflation, have also on average outperformed during periods of rising inflation. The chart also shows the sensitivities at the end of 2021. The increased sensitivity of the momentum factor since the beginning of this year is intuitive, as more inflation-sensitive stocks outperformed the market and made their way into the momentum index. To some extent, a similar argument can also be made for value’s sensitivity declining slightly.

The variation in sensitivity that we observed in sector indexes is mainly due to the changes in sensitivity of underlying stocks in these indexes. For factor indexes, in addition to changes in the stock sensitivities the indexes are also more dynamic, and we see more changes in their constituents and weightings. Therefore, we see larger variations in inflation sensitivity in factor indexes.

 

Inflation sensitivity of MSCI USA factor indexes

This chart shows the inflation sensitivity of the MSCI USA factor indexes.

 

Seeing the big picture

Stock-level inflation sensitivity allows us to evaluate a portfolio’s sensitivity to inflation by assessing its exposure without relying on historical returns. This is especially useful when a long history of returns is unavailable, and we need to go back decades to source an inflationary period. In a follow-up blog post, we will investigate how stock-level sensitivity can be used by investors to construct portfolios aligned with their views on inflation.

 

 

1Measuring Stock Inflation Sensitivity,” MKT MediaStats, Aug. 1. 2021.

2To make the chart more intuitive, the inflation sensitivities are presented relative to the sensitivity of MSCI USA Index (i.e., relative sensitivity = sensitivity – aggregated sensitivity of MSCI USA Index).

3Markowicz, S. “Which equity sectors can combat higher inflation?” Schroders, March 24, 2021.

4“The Road Ahead: Inflation Can Go Down as Well as Up.” Man Group, May 2022. Heldmann, M. “In the fight against inflation, consider these sectors and styles.” Allianz Global Investors, Jan. 6, 2022.

 

 

Further Reading

Has Inflation Affected the Bond-Equity Relationship?

Hotter Inflation Set Some Styles and Factors on Fire

A Deep History of the Bond-Equity Relationship and InflationIs the Market Ripe for Stock Picking?

Climate Indexes Brought Short-Term Gloom with Blooming Offshoots

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