Inflation Protection: An Equity-Centric View
While the world waits and hopes for many of the supply chain related inflationary pressures to subside, the speed and pace of inflation normalization feels highly uncertain. How can an investor enhance returns during time periods when inflation exceeds market expectations?
Reducing fixed income duration, investing in TIPS (Treasury Inflation Protected Securities), or adding commodity futures are a few timeless portfolio construction ideas that can help provide more durable returns in inflationary environments -- but perhaps at a cost of sacrificing returns if inflation falls flat. So we present a slightly different approach: an equity-centric view of inflation protection that can better position portfolios for the current environment.
There’s no need to go back to the 1970s for historical perspective on performance during unexpectedly high inflation. Looking at the Citigroup Inflation Surprise Index, we isolated five more recent time periods where inflation came in hot (Figure 1).
Figure 1 - When Inflation Came In Hot...
Source: Bloomberg; Natixis Investment Managers Solutions as of 12/31/2021
Some Industries Fared Better Than Others
Which industries tended to outperform on a risk-adjusted basis during these five regimes? Equity REITs (Real Estate Investment Trusts), Metals & Mining, Oil & Gas, and Banks, to name a few. Which tended to underperform? Semiconductors, Wireless Telecom, and Auto Components were three that consistently lagged the broad market during these time periods.
Using this historical performance data, we developed a scoring system that can be applied to any equity product. Products with high allocations to industries with strong performance and low allocations to industries with weak performance during these high inflation periods will score well. These product scores can then be rolled up to the portfolio level to evaluate your overall inflation protection.
We applied this framework across the full Morningstar equity universe. This exercise highlighted a number of factors to consider when building inflation protection:
- Value/growth allocation matters. All else equal, value strategies tend to outperform in inflationary surprises. Favoring a value tilt or avoiding a meaningful growth tilt can enhance inflation protection.
- US/Non-US allocation matters less than you might think. While international equities offer more inflation protection than US equities, in our view it’s not enough to move the needle in a meaningful way.
- Small allocations to select asset classes can provide significant inflation protection at the portfolio level. Natural resources, infrastructure, real estate, and energy-focused products should be some areas to target when building inflation protection.
- Manager selection is important as well. If you use multiple managers in your larger category allocations – large cap value, for example – make sure your managers are complementary from an inflation perspective.
If you’re interested in applying this framework to the portfolios you manage, please download the slide deck, and don’t hesitate to contact your Natixis representative.
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