With rising talk of inflation, investors have been advised to consider which investments can best protect against its eroding impacts. Value companies and small cap stocks are expected to outperform the overall share market in inflationary periods, according to new research. Quality will also do well.

Consumer price indexes (CPI) of G-7 economies posted the largest increase in the second quarter of 2021 since the end of global financial crisis in 2009. Notably, the US consumer price index struck 5.4 per cent in June 2021 compared to 12 months previously, the fastest growth rate since 2008.

US finance company MSCI recently examined how different equity factors have performed in different inflationary environments from 1979 to 2021. The index provider found that value, small caps and low volatility stocks performed best during periods of high inflation, while growth performed best when inflation was low.  Quality and momentum were less sensitive to inflation and outperformed the global share market, as measured by the MSCI World Index, in all inflationary scenarios.  

‘Value’ stocks are those that have low prices relative to their financial fundamentals such as earnings. ‘Quality’ involves investing in companies with healthy balance sheets including strong earnings and low debt, while size refers to small or large companies. ‘Momentum’ refers to investing in companies with strong price trends. A growth strategy involves investment in high growth stocks.

MSCI Inflation and Factors Report

Research by Vanguard backs the finding that value stocks are is expected to outperform the growth factor stocks in inflationary periods. Vanguard expects value stocks to outperform growth stocks in US equities over the next ten-year period by as much as 5 per cent to 7 per cent per year, “and perhaps by even more over the next five years,” says Inna Zorina, a factors expert in Vanguard’s Investment Strategy Group.

“Obviously, from Vanguard’s perspective we would advise investors that diversification is the best way to control portfolio risk, but it may make sense to consider a tilt towards value securities to potentially enhance returns or restructure your portfolio if you are currently underweight value stocks,” she says.

Zorina notes that the biggest risk to value outperforming is that the US enters a recession and inflation undershoot the expected 2 per cent decade average.

“However, our advice to investors is to invest for the long term," she says. "Factor-based investing can offer benefits and outperformance, but that is over the long term. We haven't found any evidence that you can time factors." 

Exposure to factors can be achieved through a variety of investment products, including actively managed funds and exchange traded funds (ETFs). However, getting exposure to a single factor isn’t always easy. Steven Tang, head of consulting with Zenith Investment Partners, says unlike a traditional cap-weighted index, there is no defined single way to construct a factor index, with varying methodologies applied. In value, a common methodology is book value, which has shown to have better performance in inflationary environments.

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“Having said this, there’s certainly merit in having exposures to these factors, but an investor would have to accept that they may not be protected in all inflationary environments," he says.

"More broadly, if inflation was your key concern, there are asset classes outside of equities that should be considered including commodities and inflation-linked bonds.

“Assuming you wanted to implement a portfolio tilted to the above factors via ETFs, while there is a large universe available, pure exposure to some factors, in particular value, momentum and growth, aren’t as accessible in ETFs.

"However, to the above point, accessing the small cap factor could be done through traditional small cap market cap index ETFs or, to a lesser extent, through an equal weight ETF."

Seeking quality

Drew Meredith, managing director at financial planning firm Wattle Partners, favours the quality factor though all economic scenarios, including when inflation is rising. This is supported by research from fund manager Robeco that found factor strategies targeting the quality factor show relatively stable outperformance patterns over time and do not show a lot of sensitivity to macro environments, including the inflation rate.

“The inflation risk, in our view, is overstated, but regardless it will drive markets in the short to medium term," he says.

"In this environment, investors should seek higher exposures to the quality factor and be wary of overweighting the momentum factor that has largely driven returns over the last decade."

Stuart Fechner, account director, research relationships, Bennelong Funds Management, says other considerations are important, not just factors.

“In terms of making fully researched and broadly assessed investment decisions, factor-based indicators are only one element or input into what should be a multi-faceted investment research process,” says Fechner.  

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“A positive factor view or belief does not mean that all stocks within the related sector, theme or classification will benefit or perform well. In the example of a potential inflationary period, it is imperative that other stock specific factors are assessed, as they should be at all times,” he says.

“What is a company’s competitive standing within its peer group?  Does it have a competitive advantage and/or any related pricing power?  How does the elasticity of customer demand relate to a change in price?

“Should an inflationary period see a business’s headline sales increasing, at the end of the day it’s the net earnings and outcome that is important and hence the other side of the ledger, being cost management, should not be forgotten."