Is a spike in inflation the key for a return to value?

Survey conducted at Beyond Beta Europe Digital

Tom Eckett

a person in a suit and tie

The majority of European investors highlighted a pick-up in inflation as the key factor needed for value to once again outperform, according to a survey conducted by ETF Stream.

The poll question, which received 25 responses at ETF Stream’s Beyond Beta Europe Digital event, found 64% of respondents said higher inflation was the key factor for value to return after its decade-long slump since the Global Financial Crisis.

Meanwhile, some 32% of respondents highlighted quantitative tightening as the key driver for value while one respondent said a stronger US dollar.

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Value has been proven to generate positive returns during periods of higher inflation. According to research conducted by Nicolas Rabener, founder and CEO of FactorResearch, during periods of positive inflation a long-short value portfolio delivered positive returns of 0.6% versus -0.8% during periods of negative inflation.

This can be explained by higher inflation leading to higher interest rates which tends to suit value sectors such as financials and energy while growth stocks typically underperform in this environment.

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Source: Fama-French, Federal Reserve Bank of St. Louis, FactorResearch

Signs of a return of inflation have been threatening following the Federal Reserve’s decision in August to change its inflation target to allow it to run above 2%.

Previously, the Fed – like other central banks in developed markets – had an inflation rate target of 2%.

US inflation did jump higher for the third month in a row in August to 1.3%, however, it remains some way off the Fed’s target.

George Cole, an economist at Goldman Sachs, said the pick-up in inflation was more cyclical rather than signs of any long-term structural change.

“The new policy regime from the Fed is unlikely to challenge the notion that inflation is a procyclical phenomenon.

“For this reason, we expect the repricing higher of inflation and nominal rates to be cyclical rather than structural as economies recover from the Covid-19 shock.”

Value's underperformance highlights systemic problem with smart beta

This could partially explain why the majority of respondents were negative on the outlook for value. Some 48% of the 35 respondents said value would underperform over the next 12 months while 23% said the beleaguered factor would remain in line with the market.

Just 29% of respondents forecasted value to outperform the market over this period.

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Somewhat interestingly, value underperformed during the March volatility and in the rebound as well.

The MSCI World Value index has returned -11.3% versus 5.7% for the MSCI World, as at 31 August, while it has delivered annualised underperformance of 3.4% over the past 10 years.

Speaking at Beyond Beta Europe Digital, Pierre Debru, director, research, at WisdomTree, explained value’s underperformance was due to the rebound being solely in large-cap tech stocks such as the FAANGs.

Meanwhile, Gilles Prince, chief investment officer at Edmond de Rothschild, added he would need to see much higher inflation and interest rates to justify an allocation to value.

“We considered value for a long time but we did not make the allocation as the recovery was not strong enough and interest rates were simply too low,” Prince added.

The largest ETF on the European market offering exposure to value is the $1.8bn iShares Edge MSCI World Value Factor UCITS ETF (IWVL).