- When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better.
Do value stocks fare well in an inflationary environment?
It seems strange to be concerned about inflation during one of the sharpest and most severe economic downturns in our lifetimes.
However, given the Federal Reserve’s massive government spending and monetary policy, it’s something that many are thinking about as a potential risk in the not-too-distant future. The “concern” is that once the virus has been contained, the economy could overheat as a result of pent-up demand and government spending.
My initial take on this is that if we do get inflation as a result of all of this spending, it’s a good thing since it implies we’ve beaten the virus and are back to business as usual (if there is such a thing).
I’m not taking a victory lap here because I certainly didn’t expect inflation to reach nearly 8%. I hadn’t anticipated so many supply chain challenges as a result of high consumer demand.
And that piece wasn’t so much about making a macro call as it was about figuring out why value equities had fallen so far behind growth stocks in the years preceding up to the epidemic.
My conclusion was that more inflation was required for value stocks to outperform once more. Here’s how it looks:
Value has tended to do better during decades with above-average inflation and worse during decades with lower inflation, however this is not a perfect link. This was my original theory for why this happened:
Consider growth stocks in the same way that you would a bond. The purchasing value of your fixed rate income payments is reduced over time by inflation, which is why inflation is such a huge risk for bondholders.
The same can be said for growth stocks’ predicted future revenue or profit growth. Value stocks are likely to have cash flows that are already decreasing and will continue to do so in the future. As a result, higher interest rates should affect value equities less than growth companies, because the higher hurdle rate reduces the value of future growth.
Let’s put this notion to the test now that inflation has been rising for almost a year.
Since the beginning of 2021 through Monday’s closing, the DFA small and large cap value funds1 have outperformed the market and growth stocks:
During this inflationary period, value equities have excelled by a wide margin. So far, everything has gone well.
When inflation is greater, value tends to outperform for international companies as well:
It would be naive to believe that inflation is the only factor driving value or growth stocks. Inflation has a part, but nominal growth is typically higher when inflation is high.
And sometimes value outperforms growth because growth values are too far off the mark.
Because I can’t forecast the future path of inflation (and I’m not sure anyone else can either), I’m not smart enough to predict whether value stocks will continue to thrive.
However, this serves as an excellent reminder of the significance of diversifying your portfolio across economic cycles.
Since reading Ray Dalio’s The All Weather Story a few years ago, this chart from the book has stayed with me:
Because we don’t know when or why the economic environment will change, the aim is to combine investments that work under different economic regimes together.
No one predicted a major inflation/economic growth increase in 2019, yet that’s exactly what we’re experiencing right now.
In a long time, we haven’t had to deal with a rising inflation/increasing growth economy.
Value stocks have been behind for some time, but perhaps they just needed the ideal circumstances to shine.
I’m not predicting that value investment will continue to outperform. I honestly have no idea.
I’m not sure how much of the inflation story has already been priced into value and growth equities.
I’m not sure if the Fed will be able to keep inflation under control.
I am aware that building a long-term portfolio necessitates diversity of techniques that may thrive in a variety of market and economic conditions.
1Full disclosure: DFA funds are used in several of my firm’s client portfolios, and I own some of these funds.
Why do value stocks perform well in an inflationary environment?
If you invest 100 in a value business with a price/earnings (P/E) ratio of 5x, for example, that multiple means your shares should produce 20 each year in profits, and thus you will’recover’ your investment after five years. A growth company, on the other hand, is likely to have a high P/E ratio, implying low earnings now, but growth investors are willing to pay up in the hopes of generating money in years 16 to 20, rather than the first five.
That makes the value business a’short-duration’ asset and the growth business a ‘long-duration’ asset in financial terms. Regardless of the fancy verbiage, the crucial practical lesson is that money now is worth more than money in the future in an inflationary climate. The more money is invested in the future, the less it is worth. As a result, in an inflationary environment, value, which sees investors repay their money sooner rather than later, is more appealing.
Investors, on the other hand, have been significantly less anxious about inflation than deflation during the last seven years or so. Prices of goods and services typically rise with time (that is, they inflate), thus 1 buys you less and less as you look further into the future.
Deflation, on the other hand, causes prices of goods and services to fall, so your 1 will buy you progressively more things or services the further out you look. In a deflationary economy, growth firms, or those with a long-term solid franchise, are valued much higher than value enterprises.
This is why growth companies, particularly high-quality companies with pricing power so-called ‘bond proxies,’ such as food, beverage, and cigarette companies have performed so well recently. It’s also why, if you feel inflation is on its way back and we don’t have an opinion on that, either way it would reverse a big chunk of value’s recent underperformance.
Is value investing advantageous in an inflationary environment?
Value, and the environment. Stocks are a safe haven. Value companies have an advantage over growth stocks due to persistent inflation and rising interest rates.
How do you protect yourself from inflation?
If rising inflation persists, it will almost certainly lead to higher interest rates, therefore investors should think about how to effectively position their portfolios if this happens. Despite enormous budget deficits and cheap interest rates, the economy spent much of the 2010s without high sustained inflation.
If you expect inflation to continue, it may be a good time to borrow, as long as you can avoid being directly exposed to it. What is the explanation for this? You’re effectively repaying your loan with cheaper dollars in the future if you borrow at a fixed interest rate. It gets even better if you use certain types of debt to invest in assets like real estate that are anticipated to appreciate over time.
Here are some of the best inflation hedges you may use to reduce the impact of inflation.
TIPS
TIPS, or Treasury inflation-protected securities, are a good strategy to preserve your government bond investment if inflation is expected to accelerate. TIPS are U.S. government bonds that are indexed to inflation, which means that if inflation rises (or falls), so will the effective interest rate paid on them.
TIPS bonds are issued in maturities of 5, 10, and 30 years and pay interest every six months. They’re considered one of the safest investments in the world because they’re backed by the US federal government (just like other government debt).
Floating-rate bonds
Bonds typically have a fixed payment for the duration of the bond, making them vulnerable to inflation on the broad side. A floating rate bond, on the other hand, can help to reduce this effect by increasing the dividend in response to increases in interest rates induced by rising inflation.
ETFs or mutual funds, which often possess a diverse range of such bonds, are one way to purchase them. You’ll gain some diversity in addition to inflation protection, which means your portfolio may benefit from lower risk.
Where should I place my money to account for inflation?
“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.
How can I plan for inflation in 2022?
With the consumer price index rising at a rate not seen in over 40 years in 2021, the investing challenge for 2022 is generating meaningful profits in the face of very high inflation. Real estate, commodities, and consumer cyclical equities are all traditional inflation-resistant assets. Others, like as tourism, semiconductors, and infrastructure-related investments, may do well during this inflationary cycle as a result of the pandemic’s special circumstances. Cash, bonds, and growth stocks, on the other hand, look to be less appealing in today’s market.
Do you want to learn more about diversifying your investing portfolio? Contact a financial advisor right away.
What do you do with your money when prices rise?
As a result, we sought advice from experts on how consumers should approach investing and saving during this period of rising inflation.