Sergiy Lesyk
Robin Marshall
The inflation shock of 2022-23 highlights the issue of performance of different asset classes, including equity factors, in different inflation regimes[1] . Since the first Tips issuance in January 1997, there is a rich time series for short and longer run inflation expectations, using the breakevens between nominal and real yields on govt bonds.
Inflation regimes identifiable using time series on breakevens
By using shorter run (5 yr) breakevens, we can break out a series of inflation regimes over the last 20 yrs. We considered three different underlying universes: FTSE USA, FTSE Developed and FTSE All-World. We also looked at differently constructed indices, using pure factor index series for FTSE All-World and standard factor index series for FTSE USA and FTSE Developed.
Although we cannot infer strict causation from correlation between two variables, there were some striking relative performances of different equity factors in this period. Most notably, as Table 1 shows, Value underperformed substantially during the deep, disinflationary shocks of the GFC and Covid, while Quality, Momentum and Low Vol all outperformed.
Table 1: Performance of FTSE USA Factor indices,annlsd.%
| Period | Time frame | Quality | Momentum | Size | Low volatility | Value |
|---|---|---|---|---|---|---|
| Increasing inflation | Jan.03 - March 05 | -1% | -1.60% | 10.60% | 3.10% | 6.70% |
| Moderate stable inflation | April 05 - July 08 | 2.10% | 1.80% | 0.40% | 0.90% | 0.80% |
| Inflation expectations fall in GFC | Aug 08 – Nov 08 | 18.80% | 6.30% | 21.60% | 32.30% | 0.80% |
| Rising expectations after GFC QE | Dec 08 – Dec 09 | -1.50% | -5.50% | 15.60% | 9.00% | -0.90% |
| Low, stable inflation after GFC | Jan 10 - Feb 20 | 3% | 0.60% | -1.30% | 1.20% | -4.20% |
| Covid-infltn. expectations fall | Feb 20-March 20 | 199.70% | 66.50% | 89.10% | 86.60% | -91.20% |
| Covid- rising inflation expectations | April 20-March 22 | 0.90% | 0.10% | 5.10% | 6.60% | 0.50% |
| Lower inflation expectations as rates rise | April 22 - May 23 | 1.60% | -1.10% | -2.80% | 1.10% | 1.30% |
Value and size outperformed when inflation expectations rose
Generally, Size and Value factor indices performed better when inflation expectations rose, and Momentum, Low Volatility and Quality out-performed in environments of stable, but falling inflation expectations. This is consistent with evidence we found of outperformance by Size and Value during economic recoveries, as financing conditions improve[2].
There are some exceptions, such as the FTSE USA Value Index during rising inflation expectations in the recovery from the GFC. It had a negative return (-0.9% p.a.) while the FTSE All-World Pure Target and FTSE Developed value indices produced positive returns at the same time. But this may reflect the high weighting of financials in the FTSE USA Value Index, underperformance by financials after the GFC. These results proved robust when the sample size was increased by looking at higher frequency data.
Factor performance may be rationalized by investor behaviour
The results can be rationalized by investor behavior. It seems plausible that as inflation expectations rise, investors are more likely to switch to Value stocks with lower p/es and valuations. These firms typically have higher dividend yields, and less implied duration in valuations, in contrast to Growth stocks on higher p/es, where future earnings are subject to higher discount rates.
But different theories fit the same set of facts…
But higher inflation expectations can also be driven by expectations of faster economic growth, producing a stronger positive impact on smaller firms and the Size factor. In contrast the Quality and Low Volatility factors may do better in falling inflation expectations environments if investors associate it with slower growth and/or oversupply.
More recent performance of equity Factors in the Q4 rally suggests these guidelines are not fully reliable for all factors. Chart 1 shows Value and Size have performed in line with previous patterns in Q4, falling with inflation expectations, but Size has underperformed Value since July, suggesting other variables are at play, like growth expectations. Results from other factors are also more ambiguous.
Chart 1: Recent Value and Size performance and inflation breakevens
Source FTSE Russell. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
… and other drivers may overpower inflation regimes
We also note that market rallies, and sell-offs, are not born equal, and often have different drivers. A risk-on rally during a period of monetary tightening, such as the one in 2022-23, may have different equity factor characteristics from one driven by QE and zero rates.
Although we are left with the issue of different possible explanations for the same results, our initial findings appear broadly consistent. In future work, we hope to look at other macroeconomic and financial variables to support the results for inflation expectations in driving relative equity factor performance.
For a more comprehensive statistical account of the performance of equity factors during different inflation regimes, please see our longer paper.
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