There’s no denying inflation is crimping equities, which is particularly burdensome at a time when interest rates are rising, meaning broad fixed income strategies are failing as refuges from equity market weakness.
The S&P 500’s year-to-date decline of 5.77% is proof positive of that ominous scenario. This vexing scenario has advisors pondering what the best moves from an asset allocation perspective. Fortunately, there are glimmers of hope among various asset classes. And yes, that includes equities.
The Consumer Price Index (CPI), of which the March reading is due out this week, checked in at 7.9% in February – the highest mark since 1982. At levels like that, it’s nearly impossible for most bond strategies to keep pace and those that offer that potential likely involve some level of credit risk.
Today, there is no shortage of experts opining that inflation isn’t likely to remain as elevated as it is today. Some see it declining to the 3% to 4%. Of course, many don’t offer a timeline for that retrenchment and many were part of the “transitory not persistent” chorus that’s ultimately proven inaccurate. Perhaps this time, they’ll get it right.
Encouraging News for Equities
For clients that are chastened by the ongoing slumps by high-quality bonds, there is positive news as it pertains to stocks vs. inflation.
“We believe stocks are one of the best places to be in a rising inflation world. Our review of data back to the 1920s finds that equities perform well as long as inflation isn’t out of control ― over 10%, which is historically rare and not our expectation even in this unusual cycle,” notes Tony DeSpirito, BlackRock managing director. “In above-average inflation environments (5%-10%), value stocks have performed particularly well.”
Adding to the allure of stocks in inflationary times is the point that value stocks – a segment many clients are familiar with and love – often thrive during these climates. There’s confirming as the S&P 500 Value Index is modestly higher this year. A slew of related exchange traded funds are performing even better than benchmark. BlackRock’s DeSpirito points out that nearly a century’s worth of data confirm value stocks are at their best when inflation rises.
“If you think about investing time horizon, the expectation is that a value stock will return capital to shareholders faster than a growth stock, he adds. “This is because, by definition, much of the expected cash flows from lower-multiple (value) stocks is front-end loaded. Conversely, growth stocks are considered longer-duration assets with expectations of greater cash flows further into the future. In essence, a higher proportion of the stock’s price comes from far-off cash flows, and that gets discounted by higher rates. This gives value stocks, with more stable near-term cash flows, an upper hand in an inflating environment.”
Given the performance of the energy sector dating back to last year and financial services’ reputation for being rising rate winners, some clients might assume those are the best inflation-fighting sectors.
While those are among the groups that could thrive as inflation lingers, BlackRock is also constructive on industrials, materials and utilities names.
“Companies generally have been able to manage higher costs, exhibiting pricing power and a willingness to invest in cost-saving measures to propel their businesses forward. That said, rising inflation and rates is also stoking higher volatility in stocks,” concludes DeSpirto.
Bottom line: Inflation doesn’t have to cripple equity investors, but advisors need to emphasize to clients that selectivity will payoff in the current environment.