Inflationary metrics have acted as a strong predictor of US equity market returns over the last seventy years, according to a research conducted from Research Affiliates.
The paper, titled Predicting Equity Returns with Inflation, hypothesised that there is a statistically significant relationship between periods of high inflation and low equity risk premium, with inflation potentially acting as a proxy for business cycles and activity.
Testing this, authors Jim Masturzo and Michele Mazzoleni use two solutions which cover different inflation “memory” spans: an inflation cycle (current inflation rate minus exponentially weighted moving average of past inflation rates) and an investment surprise (current inflation rates minus previous month inflation rate).
Applying these indicators – meant to represent longer-term trends and ‘news’ about inflation dynamics – the authors created US equity portfolios corresponding to each and then an ‘average’ portfolio which combined the two.
All three portfolios sold holdings when the CPI was high and bought when inflation fell, and were then compared side-by-side to US stock market returns and a time-series momentum portfolio between January 1948 and December 2020.
The report noted that different metrics prospered during different time periods with cycles becoming a stronger predictor while surprises lost much of their predictive power.
“These patterns are present across the majority of the sectors,” the report said. “We infer that, for the most recent decades, inflation expectations can be better approximated by employing moving averages with longer look-back windows; the opposite is true for the period of the 1970s and 1980s.”
Regardless, all three inflation metric-linked portfolios achieved alpha versus the US stock market over the 72-year period – with the cycles and ‘average’ portfolio achieving annualised alpha between six and seven percent – while only the surprise portfolio underperformed the momentum portfolio.
“Our evidence suggests that inflation signals are indeed significant predictors of equities’ excess returns,” the report continued. “Both signals translate into statistically and economically meaningful alpha; the cycles signal delivered the strongest outperformance.”
“In particular, the premium harvested from combining the inflation signals is comparable to the one earned by the well-documented time-series momentum portfolio, while the two strategies themselves are not highly correlated.”
The researchers then applied these same methodologies to ten individual sectors to see whether some may struggle more than others during inflationary periods.
As expected, the report said, both inflation signals are negatively associated with future excess returns across all sectors measured meaning rising inflation is linked to falling returns.
However, also worth noting is the complementarity channel of goods pricing, and how this creates a knock-on effect. For instance, in fuel and cars, a price increase in one good might lead to a decrease in the demand for the other good. The report argues the most predictable industries display the highest degree of complementarity to energy and services and therefore struggle most during periods of rising inflation – though exceptions may occur.
Their inflation-signal-linked models also provided “remarkable” protection against market tail events, shorting when the market tanks and long when it rallies, as well as offering consistent performance across different inflation regimes.
“Similar to trend-following strategies, portfolios based on inflation signals display a payoff profile akin to that of an option straddle on the market,” the report added. “More generally, inflation signals tend to pay off during the most volatile economic times.”
Building an inflation portfolio using stocks
It concluded by stating positive values (rising inflation) of the cycle and surprise signals tend to predict economic contractions over the subsequent year, while negative values (falling inflation) tended to predict economic expansions. In turn, the ‘average’ signal portfolio should generate long positions when a bull market is established and shorts during bear markets.
Speaking on the robustness of the signals applied, the report said: “We demonstrate that this predictability translates into new sources of alpha that investors can seek to harvest.
“In particular, we highlight the signals’ ability to perform during the worst times in the stock market without missing upside opportunities.”