Factoring in Inflation

In March, inflation reached heights not seen since December of 1981 as supply chain disruptions stemming from the ongoing global pandemic and open conflict in Eastern Europe continued to put upward pressure on prices. While many pundits believe we have seen the worst of it, higher than normal inflation appears to be here for a while longer.

Source: Ycharts, Bureau of Labor Statistics

As you can see above, the surge in prices seen over the last year has not been seen since the 1970s. While this more recent surge has been partially offset by robust growth in wages over the same time frame, investors are questioning how to best allocate their investments in an inflationary environment. To help answer that, we can look right to factors.

Factors and Inflation

Factor investing provides a great defense against an inflationary environment. Small stocks, value stocks, profitable stocks, and momentum stocks all tend to outperform in the face of elevated inflation. Small-cap stocks have consistently beat inflation as far back as data persists. Why?  One theory points to smaller companies being more agile and able to pivot in an inflationary environment.

Source: Bureau of Labor Statistics, Center for Research in Security Prices (CRSP)

Momentum, the tendency of stocks performing well to keep performing well, also tends to perform well under inflationary pressures. This may well be because strong price momentum may indicate an ability to pass increased input costs to the consumer due to pricing power.

Profitability, like momentum, also appears to be able to pass on higher costs to maintain strong earnings. Profitable companies also tend to have stronger balance sheets and cheaper sources of capital to allow them to perform well in market disruptions.

Last but certainly not least is the value factor. Value stocks are defined as companies with a low value relative to their intrinsic value (on sale). Value has a history of outperforming growth in the face of inflation. To think through why this is, it’s probably worth taking a step back to remind ourselves of what exactly a stock price represents. Value stocks tend to see much of their value represented in near-term cash flows, whereas growth stocks, on the other hand, tend to have a lot of value in more distant earnings. The price of a stock should represent the value of that company’s future earnings. In an inflationary environment, the upward pressure on interest rates tends to reduce the value given to longer-term earnings, which impacts growth stocks more. As a result, value stocks perform relatively well in comparison. We are seeing that in spades this year. Growth stocks have been slammed and are down almost 20%, whereas value stocks are down just a little over 5%.

Source: Ycharts, FTSE Russell

In sum, a diversified portfolio with factor exposure is positioned well to navigate a stubbornly persistent inflationary environment. We don’t know when or how fast inflation will return to more normal levels, but in the meantime, it makes sense to lean into pockets of the market that have held up in the face of previous bouts of inflation.