Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 477

Investing across deflation, inflation and stagflation

with Laurens Swinkels and Pim van Vliet

After three decades of muted price increases, inflation has once again become a major talking point for investors. A confluence of factors such as the reopening of economies following protracted Covid-related lockdowns, supply chain bottlenecks, sharply rising commodity prices (particularly gas and oil) and Russia’s invasion of Ukraine have driven global inflation well beyond comfortable levels.

Given the environment, it is worth looking into how risk premiums typically behave across different inflation regimes, such as periods of deflation or high inflation. In our study1, we examined the performance of asset classes and factors using a deep sample stretching back to 1875, thereby accounting for various and numerous inflation regimes.

Behavior of asset classes in different inflation buckets

We observed that inflation varied over time and was punctuated by periods of deflation, moderate inflation and high inflation. Moreover, there were a few periods during which high inflation coincided with a recession, i.e. stagflation. Figure 1 depicts the inflation cycle over our 146-year sample period, with the grey bars indicating recessions.

Figure 1 | Inflation cycles over 146-year period, January 1875 to December 2021

Source: The chart shows the inflation cycles from January 1875 to December 2021. For inflation we used year-on-year CPI data for France, Germany, Japan, UK and US from Datastream and MacroHistory.

To assess the impact of inflation on asset and factor returns, we chose to distinguish four broad types of inflation regimes: deflation (<0%), low inflation (0-2%), mildly overshooting inflation (2-4%) and high inflation (>4%). Table 1 summarizes the average annual returns for traditional asset classes across the different inflation buckets over our sample period.

Table 1 | Asset class returns across different inflation buckets, January 1875 to December 2021

Source: The table shows the asset class returns across various inflation buckets from January 1875 to December 2021. For equities, we used return data from the MSCI World Index and before then global value-weighted equity market returns, see Baltussen, Swinkels and Van Vliet (2022). For bonds, we used return data from the Bloomberg Global Treasury Index and before then GDP-weighted bond returns across French, German, Japanese, UK and US bond markets, see Baltussen, Swinkels and Van Vliet (2022). For cash, we used return data based on short-dated US Treasuries from the Kenneth French library and before then data from Jeremy Siegel. For inflation we used year-on-year CPI data for France, Germany, Japan, UK and US from Datastream and MacroHistory. All returns are quoted in USD.

During deflationary periods, equities delivered nominal returns well below their average over the sample period, but above-average real returns due to the negative inflation. The outcome was similar for cash, with above-average real returns. Bonds benefited over this period, generating above-average nominal and real returns, with the latter being particularly strong.

In high inflation intervals, all the asset classes experienced positive returns, but equities and bonds lagged their averages. But more importantly, all asset classes delivered negative real returns as they failed to offset the heightened inflationary pressures.

The low inflation and mildly overshooting inflation scenarios reflect a ‘goldilocks’ environment, which is typically good for risk assets and was prevalent for more than half of the sample period. In line with expectations, equities displayed their strongest performance in these periods, attaining robust nominal and real returns. Meanwhile, bonds fared reasonably well, delivering nominal returns in line with their average and solid real returns. By contrast, nominal cash returns were below average, but positive in real terms.

Multi-asset impact and the typical 60/40 portfolio

We then assessed the impact of these different inflation regimes on a generic multi-asset portfolio that consists of 60% equities and 40% bonds. As depicted in Figure 2, we observed that the low inflation and mildly overshooting inflation buckets (‘goldilocks’ environment) were the sweet spot for multi-asset investors both in terms of nominal and real returns.

Figure 2 | Nominal and real returns of generic multi-asset portfolio across different inflation buckets, January 1875 to December 2021

Source: The chart shows the nominal and real returns of a multi-asset portfolio across various inflation buckets from January 1875 to December 2021. For equities, we used return data from the MSCI World Index and before then global value-weighted equity market returns, see Baltussen, Swinkels and Van Vliet (2022). For bonds, we used return data from the Bloomberg Global Treasury Index and before then GDP-weighted bond returns across French, German, Japanese, UK and US bond markets, see Baltussen, Swinkels and Van Vliet (2022). The generic multi-asset portfolio consists of 60% equities and 40% bonds, rebalanced monthly. For inflation we used year-on-year CPI data for France, Germany, Japan, UK and US from Datastream and MacroHistory. All returns are quoted in USD.

In deflationary times, nominal returns from multi-asset portfolios were subdued, but materially better in real terms. By contrast, nominal multi-asset returns were solid in periods of high inflation, but these were eroded by heightened price pressures leading to negative real returns.

Impact on factor premiums across various inflation regimes

We carried out the same exercise for factor premiums across both equities and government bonds. This is illustrated in Figures 3 and 4, where the factor returns are the differences in performance between a long portfolio with the highest factor exposures and a short portfolio with the lowest factor exposures. Interestingly, we saw that the performance of factors seemingly does not depend much on the level of inflation, in contrast to the asset class returns.

Indeed, Figure 3 shows that the multi-factor equity portfolio produced fairly stable performance across all four regimes. At the individual factor level, the variation in returns across inflation buckets was somewhat higher, but never strayed too far away from long-term averages.

Figure 3 | Equity factor premiums across different inflation buckets, January 1875 to December 2021

Source: The table shows equity factor returns across various inflation buckets from January 1875 to December 2021. For the equity factors, we used data from the Kenneth French library and Baltussen, Van Vliet and Van Vliet (2022) 2 and methodology from the latter. The equity factor returns are based on the return spreads between the top and bottom factor quintile portfolios using US stocks. For inflation we used year-on-year CPI data for France, Germany, Japan, UK and US from Datastream and MacroHistory. All returns are quoted in USD.

The picture for bond factors was similar as they delivered positive returns in all four regimes as depicted in Figure 4, while the multi-factor bond portfolio performed consistently well in all inflation buckets. At the individual factor level, the variation in returns across the different inflation scenarios was higher, leading to a well-diversified multi-factor bond portfolio.

Figure 4 | Bond factor premiums across different inflation buckets, January 1875 to December 2021

Source: The table shows bond factor returns across various inflation buckets from January 1875 to December 2021. For the bond factors, we used data from Baltussen, Martens and Penninga (2022) 3 and methodology from the latter. The bond factor returns are based on the return spreads between the top and bottom factor quintile portfolios. For inflation we used year-on-year CPI data for France, Germany, Japan, UK and US from Datastream and MacroHistory. All returns are quoted in USD.

Asset classes struggle during stagflation but factors provide some reprieve

We acknowledge that not all inflation regimes are alike. Periods of high inflation that coincide with recession particularly stand out. We therefore scrutinized the impact of stagflation on asset class and factor premiums. We found that the nominal (-7.1%) and real (-16.6%) returns for equities were especially weak in these episodes. This suggests that the asset class is a poor hedge during these occasions.

The outcome was somewhat better for bonds as falling interest rates typically present tailwinds for the asset class. During these stagflationary intervals, bonds delivered a nominal return of 5.1%, but a real return of -4.4% due to the high levels of inflation. Overall, a generic multi-asset portfolio tended to struggle in this scenario as it produced nominal and real returns of -2.2% and -11.7%, respectively.

The picture was different when we looked at factor premiums. The multi-factor equity and multi-factor bond portfolios charted in positive territory with gains of 5.4% and 4.7%, respectively. Moreover, all equity and bond factor premiums performed well during stagflation, with the exception of the bond momentum factor which endured losses during these episodes. In other words, equity and bond factors also performed consistently in periods of stagflation, thereby providing some reprieve from poor asset class returns during these periods.

Conclusion

Our findings reveal that asset class premiums vary substantially across inflation regimes. Deflation and moderate inflation scenarios generally result in positive nominal and real equity and bond returns, while real returns suffer in times of high inflation, especially during periods of stagflation.

Meanwhile, equity and bond factor premiums are generally consistent across all inflation regimes, with marginal variations in returns across inflation regimes. Although this may sound unexciting, it does imply that factor investors should, on average, be less affected by inflation. As a result, we conclude that factors can help alleviate the pain during high inflation periods, albeit they are not a perfect hedge against inflation.

Read full research paper

1 Baltussen, G., Swinkels, L., and Van Vliet, P., June 2022, “Investing in deflation, inflation, and stagflation regimes”, SSRN working paper.
2 Baltussen, G., Van Vliet, B., and Van Vliet, P., March 2022, “The cross-section of stock returns before 1926 (and beyond)”, SSRN working paper.,
3 Baltussen, G., Martens, M., and Penninga, O., January 2022, “Factor investing in sovereign bond markets: deep sample evidence”, Journal of Portfolio Management.

 

Guido Baltussen is Head of Factor Investing, Laurens Swinkels is a Researcher, and Pim van Vliet is Head of Conservative Equities and Head of Quantitative Equities at Robeco Quantitative Investments.

 


 

Leave a Comment:

     

RELATED ARTICLES

How inflation impacts different types of investments

Passive investing has risks too

Not all private markets are ‘volatility laundering’

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever

In his recent shareholder letter, Warren Buffett mentions several stocks he expects Berkshire Hathaway will own indefinitely, including Occidental Petroleum. We look at ASX stocks that investors could buy and hold forever.

The best strategy to build income for life

Owning quality, dividend-producing industrial shares is key to building a decent income stream. Here is an update on the long-term performance of industrial stocks against indices, listed property, and term deposits.

Are more taxes on super on the cards?

The Government's broken promise on tax cuts has prompted speculation about other promises that it may consider breaking. It's widely believed that super is lightly taxed and a prime candidate for special attention.

Lessons from the battery metals bust

The crash in lithium and nickel prices has left companies scrambling to cut production, billionaires red-faced, and investors wondering how a ‘sure thing’ went so wrong. There are plenty of lessons for everyone.

Welcome to Firstlinks Edition 545 with weekend update

It’s troubling that practical skills like investing aren’t taught at schools as it leaves our children ill-equipped to build wealth, and more vulnerable to bad advice. Here are some suggestions to address the issue.

  • 1 February 2024

For the younger generation, we need to get real on tax

The distortions in our tax system have been ignored for too long, and we're now paying the price. It's time Australia got real and addressed the problems to prevent an even greater intergenerational tragedy.

Latest Updates

Shares

16 ASX stocks to buy and hold forever

In his recent shareholder letter, Warren Buffett mentions several stocks he expects Berkshire Hathaway will own indefinitely, including Occidental Petroleum. We look at ASX stocks that investors could buy and hold forever.

Investment strategies

Clime time: 10 charts on the outlook for major asset classes

The charts reveal that interest rates can't rise much further as Australian mortgage holders are under stress, bank dividends look solid, and the bond market is in flux because yields are being manipulated.

Strategy

Phasing out cheques, and what will happen to cash?

Cheques and bank service, or the lack of, were major topics when I addressed a seniors’ group recently. The word had got out that the government was phasing out cheques, and many in the audience were feeling abandoned.

Retirement

What financial risks do retirees face?

Treasury's consultation into the retirement phase of superannuation is generating a lot of interest. This submission to the consultation outlines the key financial risks to an individual’s standard of living in retirement.

Shares

Recession surprise may be in store for the US stock market

Markets are partying like it's 1999, but history suggests that US earnings and economic growth are vulnerable following an interest rate tightening cycle. Investors should prepare their portfolios accordingly.

Investment strategies

3 under the radar investment opportunities

The Magnificent Seven are hogging the headlines, yet there are plenty of growth opportunities elsewhere, at a fraction of the cost. Here are three stock ideas riding key areas of structural and cyclical change.

Shares

Why a quant approach can thrive in the age of passive investing

The rise of passive investing is unlikely to derail the value of quantitative strategies. Passive investing hasn’t eradicated the irrationality of crowds, leaving pockets of opportunity to outperform indices.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.