- We’ve seen a sharp rise in inflation during 2021, led by rising energy prices, while food-related inflation was low.
- Rising inflation has historically benefited commodity producers and high-dividend yield companies and has been unfavorable to growth stocks, as well as consumer services and information technology companies.
- The MSCI ACWI Commodity Producers Index has outperformed broad equity markets in periods of rising energy inflation; the MSCI ACWI Agriculture and Food Chain Index when food inflation and core inflation (excluding food and energy) have risen.
Inflation in developed economies witnessed a sharp increase in the second quarter of 2021, with consumer price indexes (CPI) of G-7 economies registering the highest increase since the end of global financial crisis in 2009.1 Notably, the U.S. consumer price index hit 5.4% in June compared to 12 months previously. Equities, as an asset class, have traditionally been viewed as a hedge against inflation, based on the assumption that companies’ revenues adjust for inflation over time. But what has been the short-term impact on equity portfolios? In this blog post, we look at how equity investors could have hedged against rising inflation by examining how different industry and style factors were affected.
Breaking Down Inflation
The COVID-19 crisis led to central banks and governments injecting monetary stimulus estimated to be over USD 10 trillion globally.2 Excess money supply combined with pandemic-related pent-up demand for products and supply-chain disruptions resulted in a rise in inflation.
Looking at the components of inflation, however, it is interesting to note that the headline inflation (all items measured by the CPI) was driven by the energy and core components, while food inflation actually declined.3 Historically, G-7 headline inflation has been driven largely by energy, which has experienced the biggest swings, while food and core inflation have typically lagged energy by six- and 12-months respectively. This has been due to the fact that energy is a cost across most of the economy, and rising energy prices get transmitted to food and core prices as second-round effects.
Inflation Evolution Across Components
Source: The Organization for Economic Cooperation and Development (OECD) database.
Inflation’s Effects by Industry and Style Factors
In the short-term, companies that can easily transfer higher costs to consumers have been more resilient in the face of rising inflation. And companies that provide raw materials have tended to benefit. In short, it is important to look at individual segments of equity markets when assessing inflation’s impact.
We looked at the correlation between industry and style factors in the MSCI Global Equity Model for Long-Term Investors (GEMLT) and the change in inflation from December 1998 to May 2021. We found that:
- Commodity-producing industries, such as oil and gas exploration and production, gold and steel, as well as automobiles and components and machinery, exhibited the strongest correlations with “CPI All Items” and “CPI Energy,” as shown in the exhibit below.
- Industries within the information technology and consumer services sectors, on the other hand, were negatively affected by rising inflation.
Correlation of style factors with changes in inflation were smaller in magnitude, but still were present:
- The dividend-yield factor showed a high correlation with headline inflation, as dividend-paying companies tend to have strong prevailing (short-dated) cash flows that could benefit from inflation.
- The growth factor was negatively correlated with inflation, alongside the beta factor, as investors may perceive rising inflation as a precursor to high interest rates and slower growth.
Correlation of GEMLT Industry and Style factors with Changes in Inflation
Data from December 1998 to May 2021.GEMLT industry factors with history under 20 years were not included in the analysis.
Putting Industry- and Style-Factor Data to Work
One way that investors have hedged against inflation has been to tilt toward industry segments that have benefitted from rising inflation. To test that approach, we examined two indexes — the MSCI ACWI Commodity Producers Index and the MSCI ACWI Agriculture and Food Chain Index — that aim to have exposure to commodity producers and agriculture producers, respectively.4
Over the period of analysis, both indexes showed implicit negative exposure to the growth factor and mostly high exposure to quality factors compared to the parent MSCI ACWI Index. The MSCI ACWI Commodity Producers Index had high exposure to beta, as it contains more cyclical industries. On the other hand, the MSCI ACWI Agriculture and Food Chain Index was more defensive, i.e., had lower beta exposure.
Active GEMLT Style Factor Exposures Relative to the MSCI ACWI Index
Data from December 1998 to May 2021
Historically, the higher-beta MSCI ACWI Commodity Producers Index has shown high correlation with CPI All Items (0.34), driven by its high correlation with CPI Energy (0.27) and CPI Core (0.26). The more defensive MSCI ACWI Agriculture and Food Chain Index has been negatively correlated with CPI Energy (-0.22), and therefore CPI All Items (-0.07), but has shown a positive correlation with CPI Core (0.16) and CPI Food (0.15). This makes sense given that high energy prices are a cost to agricultural producers while high food prices typically increase their profit margins.
We also analyzed the performance of the two indexes relative to the MSCI ACWI in rising and falling inflation environments. The MSCI ACWI Commodity Producers Index showed strong performance conditionality on CPI All Items and CPI Energy. On average, it outperformed the MSCI ACWI by 53 basis points (bps) per month in rising inflation periods. The MSCI ACWI Agriculture and Food Chain Index’s performance was dependent on CPI Core and CPI Food inflation with 49 bps of outperformance during increasing core-inflation periods.
Correlation with Inflation and Performance in Different Inflation Regimes
The correlations of excess returns over the MSCI ACWI and change in CPI from December 1998 to May 2021. Months in which the current level of CPI was lower (higher) than the 36-month moving average were termed as falling (rising) inflation periods.
Different Ways to Hedge Inflation
Different segments of equity markets are affected by inflation hikes in different ways, which is broadly determined by the impact of inflation on their operational costs and revenues. Our analysis indicated that commodity-focused stocks (as proxied by the MSCI ACWI Commodity Producers Index) and agriculture-focused stocks (as proxied by the MSCI ACWI Agriculture and Food Chain Index), illustrate how hedges against headline and core inflation, respectively, can be created.
1The data on G-7 CPI is obtained from the Organization for Economic Cooperation and Development (OECD) database.
2“Total stimulus for the COVID-19 crisis already triple that for the entire 2008–09 recession.” 2020. McKinsey & Co.
3Core inflation includes household expenditure related to housing, health, education and communication but excludes the more volatile components: food and energy.
4The MSCI ACWI Agriculture & Food Chain Indexes are free-float-adjusted market capitalization indexes designed to track the performance of globally listed producers of agricultural products, fertilizers & agricultural chemicals, packaged foods and meat and food distributors. The MSCI Commodity Producers Indexes are free-float-adjusted market capitalization indexes designed to track the performance of globally listed commodity producers.
Further Reading
How Might Inflation Impact Funding Ratios?
Stress Testing Multiperiod Inflation Scenarios
How Inflation Could Affect Multi-Asset-Class Portfolios