- We demonstrate how investors can use stock-level inflation sensitivities to construct portfolios to express their views on inflation.
- We show how a hypothetical portfolio of stocks with high (positive) inflation sensitivity would have outperformed the broad market during the recent inflation spike.
- Regardless of an investors’ views on inflation, they can use stock-level sensitivity as they determine whether and how to position portfolios.
While the high-inflation environment and its impact on asset prices are on most investors’ minds, some investors may also be contemplating whether inflation has peaked following the swift action by global central banks. As shown below, the five-year breakeven-inflation rate has dropped from its high of 3.6% in March to 2.7%.
In our previous blog post, we discussed how stock-level inflation sensitivity can be used to assess a portfolio’s sensitivity to inflation. Using data from MKT MediaStats,1 we looked at the inflation sensitivity of various MSCI USA sector and factor indexes and their variation over time.
In this blog post, we investigate the potential of using the stock-level inflation sensitivity to construct hypothetical portfolios aligned with investors’ views on inflation. These views may range from “inflation is here to stay and could rise from the current level,” to “it has peaked, and we could see a drop in inflation from here.”
US five-year breakeven inflation down from its highs
Source: Federal Reserve Bank of St. Louis’s FRED database
Measuring stock-level inflation sensitivity
The estimates of stock-level inflation sensitivity are calculated by regressing stock returns on several macro signals, such as breakeven inflation and oil and gold prices, while incorporating inflation sentiment derived from news articles. The final sensitivity is calculated as a score ranging from 1 to 10, with 10 representing stocks that have historically shown the best performance in response to higher inflation. The use of sentiment in the calculation aims to capture the stock-price behavior not only to inflation itself, but to investors’ views and expectations of inflation. We show the distribution of scores for the constituents of the MSCI USA Index below.
Distribution of the MSCI USA Index’s inflation-sensitivity score
As of June 30, 2022. Source: MKT MediaStats.
Building an inflation-aware portfolio
We use these inflation sensitivities to create hypothetical portfolios with a positive (or negative) sensitivity to inflation. To view the behavior of these portfolios on a historical basis, we created two sample portfolios of 100 stocks from the constituents of the MSCI USA Index. The Top100 portfolio includes stocks with the highest inflation sensitivities and the Bottom100 portfolio comprises stocks with the lowest sensitivity. Stocks in each portfolio are also given weights proportional to their weight in the MSCI USA Index. The portfolios are rebalanced quarterly.
Below we detail the performance of these two portfolios relative to the MSCI USA Index. During the inflation rise of the recent past, the Top100 portfolio moved in tandem with inflation and the U.S. consumer price index.2 Over this period, the Bottom100 portfolio showed negative active return, although most of its underperformance is due to the past seven months. During the period of relatively muted inflation from 2012 to 2020, the two portfolios don’t show significant inflation-related behavior.
Inflation-sensitive portfolios through changes in US inflation
Inflation based on the U.S. consumer price index (CPI).
We show below the two inflation-sensitive portfolios’ active exposures to different sectors. While the exposures varied over time, sectors such as energy and industrials were mostly overweight in the Top100 portfolio and underweight in the Bottom100 portfolio. Exposure to the health-care sector was primarily negative and positive in the Top100 and Bottom100 portfolios, respectively, over time. However, the current Top100 and Bottom100 portfolios are overweight and underweight this sector. One reason behind changes in sector exposure is that our analysis began in 2012, which encompasses a long period of low inflation. The recent rise in inflation has pushed these hypothetical portfolios’ exposures to some sectors to historical extremes.
Inflation-sensitive portfolios' sector exposures
Data from Feb. 29, 2012, to June 30, 2022.
Feb. 29, 2012, to June 30, 2022.
Addressing the inflation challenge
Stock-level inflation sensitivity can help investors assess a portfolio’s exposure to inflation, but it can also provide information as they determine whether to adjust or construct their portfolio based on their view on inflation. We showed how simple hypothetical portfolios constructed using stock-level inflation sensitivity have responded to the recent hike in inflation. The sector analysis showed while these portfolios show overweight and underweight to different sectors, they had a relatively balanced representations from all sectors. This is in line with our previous observation where we saw variation in inflation sensitivity within each sector.
1“Measuring Stock Inflation Sensitivity.” MKT MediaStats, Aug. 1. 2021.
2“Consumer Price Index for All Urban Consumers: All Items in U.S. City Average, Percent Change from Year Ago, Monthly, Seasonally Adjusted.” Federal Reserve Bank of St. Louis’s FRED.
Inflation Sensitivity and Equity Returns
Analyst Sentiment as a Factor Consideration
Value Construction as a Performance Driver