Inflation: what’s next, and how to position portfolios

There’s one mantra that may be playing out in the minds of central bankers today: be careful what you wish for. For over a decade, monetary policymakers around the world have tried to stoke persistently low inflation by keeping interest rates low.

The idea is that a modest level of inflation is good for an economy because it stokes demand (consumers would rather buy now before prices go up more), which increases production, employment, and overall growth. Igniting inflation has proven to be a challenge for the U.S. Federal Reserve (Fed) since the mid-1990s as global growth has remained sluggish and technology investment has created massive efficiencies, putting downward pressure on prices. Even with the Fed doing significant rounds of quantitative easing and a near zero percent interest-rate policy, it still was unable to create inflation that reached its 2% target.

“The CPI surge is due to extraordinary supply and demand imbalances created by the pandemic and our response to it.”

The good news for those wondering how to fuel inflation? We just found out. The U.S. Core Consumer Price Index (CPI) (a common measure of inflation ex-food and energy) sits at 4.04% as of September, versus a 20-year average of 1.99%. The CPI surge is due to extraordinary supply and demand imbalances created by the pandemic and our response to it. 

On the supply side, businesses reacted quickly when COVID-19 hit, shutting down factories, halting services, shedding inventory, and laying off millions of workers. Just as quickly, the economy reopened and businesses began to restart, hiring back labor and bringing factories back online—all at the same time. The task has been further complicated as extended unemployment benefits incented some workers to stay home.

Meanwhile, we’ve seen a massive surge in consumer and business demand fueled by stimulus totaling 50% of U.S. GDP (a response only ever seen during wartime). Lack of supply + labor shortages + swelling demand = the inflation perfect storm.

Source: FactSet, as of 9/30/21. YoY refers to year over year. 

Ultimately, we think the perfect storm will pass and that structural forces such as efficiency-creating technology will reassert themselves, putting downward pressure on prices. We also see positive base effects fading as the inflation “math” starts to work in the other direction. In other words, high year-over-year readings in 2021 are being driven by a very low starting point in 2020, as we experienced deflation during the height of the pandemic. Once this impact fades, likely in the early part of 2022, the year-over-year readings will be driven by a higher starting point.

However, because the events of the past 18 months have been so extraordinary, we simply don’t know how long these supply and demand imbalances will last. With inflation remaining a risk, how should investors position portfolios?

Our analysis suggests that stocks tend to do well in periods of higher inflation. We looked at rolling 12-month average total returns across different inflationary (headline CPI) periods, from less than 1% to over 4%, for major U.S. equity style/cap indexes. The data suggests that stocks in general do well when inflation is over 1% and under 4%. What also comes across is that in low inflation periods growth stocks tend to hold up, but in higher inflation environments mid caps/value tend to be the best performers.

While we see inflation coming back down into mid next year to the 2% to 3% range, it’s staying elevated longer than we expected. The way we look to manage inflation risk is by leaning modestly into stocks over bonds, and by emphasizing U.S. mid caps across equity allocations in portfolios.

Source: FactSet, Federal Reserve Bank of St. Louis, 11/30/1979 to 9/30/2021. The Russell 1000 Value Index tracks the performance of publicly traded large-cap companies in the United States with lower price-to-book ratios and lower forecasted growth values. The Russell 1000 Growth Index tracks the performance of publicly traded large-cap companies in the United States with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Index tracks the performance of approximately 800 publicly traded mid-cap companies in the United States. The Russell 2000 Index tracks the performance of approximately 2,000 publicly traded small-cap companies in the United States. It is not possible to invest directly in an index.

It’s important to remember that company earnings are nominal (not adjusted for inflation). The companies with the most significant advantage when inflation goes up are ones with high operating leverage.

The concept of operating leverage is simple: Businesses with greater fixed costs (think property, plant, and equipment) can amplify profits when the price people pay for their products goes up while their costs remain relatively intact as they already own the fixed asset investment. In other words, these companies can increase profits/margins because there’s relatively small additional expense to produce their product.

U.S. value and mid-cap stocks, which have an overweight in companies with high operating leverage, in our view, are an attractive way to have some offense in a portfolio as we ride the wave of higher inflation.

In our Market Intelligence outlook, U.S. mid-cap stocks have been our highest conviction asset class in 2021 as they tend to do well in a midcycle environment. Another reason to consider them for portfolios today is they can be compelling inflationary beneficiaries in portfolios.