Research Affiliates: How inflation predicts equity returns

Research Affiliates: How inflation predicts equity returns

Inflation Equity
Jim Masturzo (Foto Archief  Research Affiliates).jpg

By Jim Masturzo, CIO of Multi-Asset Strategies at Research Affiliates Global Advisors

Two new signals - inflation cycles and inflation surprises - can aid in predicting equity returns. Relying on this predictability, we design a novel equity market-timing strategy and a sector-rotating strategy.

Investment professionals expend a great deal of effort forecasting the path of the inflation rate and assessing the implications of that expected path on capital markets. Our research indicates that a model of inflation shocks, created without any forecasting of the path of inflation, is useful in predicting equity returns. We find that two derived US inflation signals - inflation cycles and inflation surprises - have been robust predictors of US equity returns over the last 71 years.

Why Is inflation a good predictor of equity returns?

We examined the average excess returns of the US stock market conditional on the contemporaneous year-over-year (YoY) inflation level for the period January 1948 to December 2020 (throughout our analysis, we use seasonally unadjusted All Items CPI). Our findings align with those of other researchers, who have also shown a statistically significant relationship: higher inflation/lower equity returns. The negative relationship between inflation rates and equity returns may be unexpected to some because equities are a claim on real assets and, therefore, should provide a hedge against inflation.

Our key analytical innovation is to interpret the difference between current and past inflation rates as a proxy for the state of the economy to predict equities’ excess returns. Underpinning our approach is the belief that the business cycle is related to investors’ risk appetites.

The two inflation signals

We obtain an inflation cycle by subtracting from the current inflation rate (the YoY change) an exponentially weighted moving average of past inflation rates, which effectively ‘smooths’ the 10-year moving average. We derive an inflation surprise as the difference between the current inflation rate and the previous month’s inflation rate.

Intuitively, an inflation cycle is indicative of longer-term trends in the growth rate of inflation, whereas an inflation surprise reflects new information about inflation dynamics. We find a near-zero correlation between the two signal series over our study period (1948–2020), suggesting the signals capture different aspects of inflation dynamics.

Applying the signals in a strategy

My recent article Predicting Equity Returns with Inflation (co-authored with my Research Affiliates colleague Michele Mazzoleni) provides full details on the signals’ demonstrated ability to predict US equity-market and equity-sector returns as well as how we apply them in an equity market-timing strategy and an equity sector-rotating strategy. These strategies are both directional and cross-sectional in nature, but have low correlation to simple trend or cross-sectional momentum strategies that focus on price changes and instead translate into new sources of alpha that investors can seek to harvest.

We also document that combining the portfolios derived from these inflation signals has been able to provide protection against the worst economic times, regardless of whether those times were driven by inflationary or deflationary pressures. Particularly desirable are the tail-hedging properties derived from these inflation signals, providing an alternative to other inflation-shock hedging options that can be costly, especially when inflation is low.

As we have seen recently, strategic allocations to alternative assets, such as commodities, as a means to protect against inflation have not fared well, with commodity indices down more than 30% since 2011. Consequently, many asset owners are unable to stay the course if inflation fails to materialize in the medium term. These inflation signals offer investors a new tool with which to hedge their portfolios against inflation and deflationary risks.

Disclaimer: please refer to our disclosures