Positioning Portfolios for Fading Inflation
Earlier in 2022, supply-chain-related inflationary pressures dominated headlines, and we suggested that the pace of normalization was uncertain. This led us to develop a framework to evaluate the inflation-sensitivity of equity portfolios. The idea was two-fold: First, investors with no view on the inflation outlook could diversify their portfolios by allocating to strategies positioned to outperform in rising inflation environments as well as strategies positioned to benefit from declining inflation environments. Our research suggested that many investors unknowingly have portfolio tilts toward one or the other, particularly when recent performance influences manager selection decisions. Second, for investors looking to make a tactical tilt, adding inflation protection to a portfolio would help position for outperformance in the event that inflation accelerated and remained persistently high for the next several months.
Has Inflation Peaked?
As we begin to see year-over-year inflation showing signs of peaking, our focus is shifting toward positioning to benefit from disinflation. While we haven’t seen clear and convincing evidence that inflation is rolling over in the commonly followed CPI (Consumer Price Index), there are some recent developments that lead us to believe that inflation is set to decelerate in the months and quarters ahead: falling/stabilizing commodity prices, falling shipping costs, normalizing supply chain constraints, goods inventory gluts, a stronger US dollar, and fading pandemic effects.
So what portfolio shifts can you make to reposition for this environment? Lengthening duration, shifting from TIPS (Treasury Inflation-Protected Securities) to nominal Treasuries, and reducing commodities exposure are traditional ways to lighten up in your portfolio inflation hedges. But we’d like to highlight an alternative approach that focuses on repositioning an equity sleeve.
As noted previously, there’s no need to go back to the 1970s for historical perspective on equity performance during periods of unexpected inflation. Looking at the Citigroup Inflation Surprise Index, we isolated recent time periods characterized by unexpectedly high and low inflation prints (Figure 1).
Figure 1 – Inflation Environments Since 2004
Source: Citigroup; Natixis Investment Managers Solutions
Risk-adjusted performance in these high inflation regimes showed clear differentiation at the industry level. Equity REITs (Real Estate Investment Trusts), Metals & Mining, and Oil & Gas were a few notable industries that outperformed, while industries like Semiconductors, Wireless Telecom, Autos, and Airlines typically underperformed. It stands to reason that as inflation-related headwinds fade, these historical underperformers will have an opportunity to lead a rebound in equity markets. Using this historical performance data, we developed a scoring system that can be applied to any equity product. Products with high allocations to inflation-protection industries and/or low allocations to inflation-fading industries receive more positive scores, while products with high allocations to inflation-fading industries and/or low allocations to inflation-protection industries receive more negative scores. These product scores can then be rolled up to the portfolio level to evaluate overall inflation sensitivity.
We applied this framework across the full Morningstar equity universe. This exercise highlighted a number of things to keep in mind as you potentially reposition your portfolio for slowing inflation.
- Value/growth allocation matters. Growth strategies have historically faced pressure from higher inflation and tighter financial conditions. Shifting some of your value to growth can help capture meaningful upside as these headwinds fade.
- Small allocations to sector-specific products can move the needle at the portfolio level. Technology, communication services, and consumer discretionary-focused products have the highest allocations to industries that have historically struggled during high inflation periods.
- US/Non-US allocation matters less than you might think. International strategies score as having better inflation protection than US strategies, but it’s not meaningful enough to warrant a major shift. Currency exposure can also play a role in the return outcome. For example, a stronger dollar can offset any return advantage from the inflation-related tilt. Ultimately, there is a wide range of inflation-sensitive and inflation-fading strategies in both US and non-US markets, so making inflation-related tilts becomes more of a manager selection exercise.
- Manager selection is important. Performance dispersion across Morningstar categories has been significant in 2022. It’s a good exercise to take a close look at drivers of recent performance and determine if now is the time to lighten up on products that have benefited (relatively speaking) from chunky allocations to inflation beneficiaries and lean into products that have more industry diversification.
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