As inflation and/or interest rates rise, discount rates increase and the net present value of an asset falls. And all things being equal, that fall is greater for long-duration equities than it is for short-duration equities.
So what kind of equities fare well during an inflationary regime from factor and sector perspectives?
How duration corresponds with factors and investment styles
Equities that are shorter duration and therefore have high near and medium-term income and forecast dividends – that is, the big, typically un-glamourous companies that generate steady income and regular cash flows – these tend to be value-style companies.
Equities that are longer duration and therefore have higher long-term earnings and potential dividends – ie a fast-growing business in a capital-intensive phase – these tend to be growth-style companies.
Companies with a value and/or income bias are expected to fare better in an inflationary regime and this theory has been supported by the data.
Companies with a value or income bias have relatively outperformed funds with a growth bias during the recent inflation spike in 2022. This trend may continue as the value rotation has further room to run.
You need real earnings to pay dividends. If a company is generating 10p per share of real earnings, it will more than likely keep pace with inflation.
This is because when interest rates go up (as they do in an inflationary regime), the value of those near-term payments is greater than the discounted value of potential growth and income that may be generated far into the future.
What does this mean for factors when inflation and interest rates are high?
The concept of investment factors was developed by the economists Eugena Fama and Kenneth French as they looked at drivers of investment returns beyond their capital asset pricing model.
They looked at the impact of size as a factor that is, market capitalisation, and also the impact of price to book value. Companies with low price to book value are value factor and those with high price to book value are growth factor.
When BlackRock analysed US equity market returns from 1927 to 2020, the results clearly illustrated that value has outperformed in all inflationary environments, particularly high-inflation environments.
Equally MSCI research on world equity data between 1994 and 2021 showed that value outpaced other factors whenever interest rates were rising.
In both instances, it is the shorter duration of value-style equities and their less-stretched valuations that underpin this performance.
Which sectors are investors tending towards in the current inflationary environment?
With inflation elevated and potentially persistent, investors have been rotating away from technology into traditionally boring sectors like consumer staples, materials and energy that benefit from rising prices or can pass on inflation.
