New research reveals what sectors and strategies do well as the cost of living rises

Inflation is here – and it doesn’t matter if you think it is transitory or not.  The question that needs to be asked is, what investment strategies have historically done well or poorly in periods of high and rising inflation?

A recent paper titled The Best Strategies for Inflationary Times by Henry Neville and others analysed 34 episodes of inflation over the past 95 years.  They reviewed the historical performance of both passive and active strategies across a variety of asset classes for the US, UK and Japan.

They found that when inflation was 5% p.a. or higher at the country level (not necessarily international) it had the greatest impact on investment returns.  Neither equities nor bonds perform well in real terms during inflationary periods though there are exceptions of course and we will mention those shortly.

Fixed interest with duration (where investors lend at fixed interest rate for many years to either corporates or governments) and high yield bonds, on average, posted negative annual returns (-8%).  The longer the maturity in years, the greater the sensitivity to rising inflation.

The annualised real return during inflationary periods is -3% p.a. for two-year bonds, -5% for 10 years and -8% for 30 years.  Inflation-linked bonds (TIPS), which can also be referred to as floating rate credit, were the only type of fixed-interest category that posted a positive real return of 2% p.a. during past inflationary periods.

As for equities, the study found that energy was one sector that delivered a positive real return (1% p.a.) during inflationary periods.  Healthcare also held up well.  The worst sector was consumer discretionary at -15% p.a. The poorer performing sectors are exposed to the individual consumer, who is likely to curb spending habits as their purchasing power is diluted by rising prices.

Hard assets such as commodities overall delivered 14% p.a. during inflationary periods.  Among the commodities, the best performer was energy at 41% p.a. followed by industrial metals at 19% p.a., gold at 13% p.a., silver at 12% and precious metals at 11% p.a.  Softer agricultural commodities delivered more modest but still positive real returns of up to 8%.  So, all commodities have positive annualised real returns and have strong positive correlation to inflationary periods.  The opposite is true during non-inflationary periods, when commodities deliver more modest returns of 1%.

Now, let’s review investment strategies.  The quality factor performs positively in inflationary periods – which basically means investing in companies with low debt, stable earnings, consistent asset growth, and strong corporate governance.  On the other hand, low-beta strategies can struggle, which maybe because low beta usually is linked to long duration and stable cashflows, specifically where they are not entirely linked to CPI.  Incidentally, momentum equity strategies have shown to be a standout performer in inflationary periods. These could be funds that are driven by short term movements in prices e.g. hedge funds. Please note past performance is not a guarantee of future performance and not every momentum strategy is expected to perform well.

Another factor found to impact investment returns is the relative inflation rates between different countries.  The varying inflation rates between countries and regions can be used as a basis for applying regional diversification in portfolios.  For example, it was found that when inflation runs low in the US and Japan but high in the UK, the investment real returns in the US and Japanese equities were actually positive 6% and 9% during the UK’s inflationary period over the past 95 years.  To put it another way, UK investors would have been well served to invest in US and Japanese equities when UK inflation was running much higher than US and Japanese inflation.

Right now, inflation is running at over 7% in the US and almost 6% in Europe, but in Australia it is currently 3.5%, which puts Australian equities in a good position to generate positive returns and may well be attractive to US and European investors.