Despite the recent chatter about inflation, inflation sensitivity generally has not been driving stock returns.
Interest rates and inflation will have varying effects on stock returns through time; those effects are difficult to predict.
The most important thing is to measure exposure to macro-related risks like interest rates and inflation at the thematic and portfolio level, to prevent macro risk from dominating other, more reliable sources of return.
Inflation has been talked about a lot in recent weeks. In the United States, for example, web traffic related to inflation reached a high peak in mid-May.1 But despite all of that chatter, inflation sensitivity has not been a primary driver of stock returns in recent months.
In the weeks since US web traffic about inflation reached its recent peak, growth and value have been the dominant themes distinguishing winners versus losers in US equity markets. Neither of those themes have much exposure to inflation (see extreme factor returns as shown in Figure 1). In addition, high-momentum and low-risk stocks both experienced slightly negative returns over the period, yet their exposure to inflation is the opposite to each other. Overall, these results suggest that inflation prospects simply aren’t having much of an impact on returns across the population of US large-cap stocks.
Figure 1: Neither Growth Nor Value Has Been Sensitive to Inflation in Recent Weeks
Returns versus Inflation Sensitivity in US large cap stocks
Interest rates and inflation are highly linked. Figure 1 shows that the sensitivity of stocks to changes in the level of interest rates and sensitivity to changes in break-even inflation have a correlation of around 0.75.
Our March commentary discussed interest-rate sensitivity in light of a massive run-up in the 10-year bond rate and concurrent big moves in the most interest-rate sensitive segments of the market (like growth and value). Since then, the relationship between growth and value and interest rate moves has become less pronounced. In addition, the sensitivity of growth and value to inflation is currently very small (see Figure 2).
The low sensitivity of growth and value to inflation makes sense to us, because the effect of inflation is difficult to anticipate. For example, inflation could be good for value if it leads interest rates to rise, but rising rates could stifle economic growth, which would support growth companies. In other words, inflation could impact growth and value positively or negatively. And that eventual impact is quite challenging to predict.
Figure 2: The Relationship Between Growth and Value and Interest Rate Moves Has Become Less Pronounced; the Two Themes Currently Have Little Relationship with Inflation
Correlation of Growth and Value Scores with Interest Rate and Inflation Sensitivity
The Bottom Line
We recognize that interest rates and inflation will have varying effects on stock returns through time, and that these effects will be difficult to predict. Even now, the narrative is rapidly shifting from worries about inflation due to an overheating economy to worries about a weak economic recovery. Either way, there’s a high degree of uncertainty about what will happen as the Fed begins to unwind its massive economic support of the economy, especially since companies are in many ways more sensitive to macro influences today due to credit market expansion.
We think the most important thing is to be able to measure exposure to macro-related risks like interest rates and inflation at the thematic and portfolio level, to prevent macro risk from dominating other, more reliable sources of return. We find that balancing our preferences for high-quality, reasonably priced companies with positive investor sentiment gives us neutral exposure to interest-rate and inflation sensitivity, and we continue to measure and monitor those exposures in our portfolios.
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