Decades of history says you can beat high inflation with quality

Factors such as momentum and value generally outperform the market irrespective of inflation, but new research suggests quality stocks are best when prices are rising rapidly

Microsoft shop
Microsoft is often included in ‘quality’ factor portfolios

Everywhere, investors are posing the same question but in different forms: what works when inflation goes haywire?

Some are rebalancing portfolios to shield against spikes and slumps in price rises. Others are studying macroeconomic data for signs of the pace at which rate hikes are slowing the economy, and wondering what that might mean for portfolios. Still more are asking whether now is the time to allocate to strategies that prosper in rising and falling inflation but may struggle at the inflection points.

The same goes for factor investing, the multi-trillion-dollar investment sector based on selecting stocks according to common features, such as low price-to-book ratios or upward-trending prices.

New research from quants at Northern Trust Asset Management looks at the problem through a truly wide-angle lens: 150 years of data. Factor investing, the quants found, has performed well in the past during periods of rapidly rising prices. The best-performing factor of all? Quality.

Assessing factor performance during inflation is not entirely straightforward. The first stumbling block is a lack of data. Over the past 30 years, periods of deflation and high inflation are few, hence the Northern Trust researchers’ choice to extend their dataset to 1875.

By doing so, the firm was able to include periods of hot inflation in the 1880s, around World War I and World War II, and in the 1970s, as well as the deflationary regimes that often followed.

Northern Trust divided the past into four common regimes: times when inflation was below zero, between zero and 2%, between 2% and 4%, and periods of high inflation – above 4%.

While stocks, generally, performed well in moderate and mildly high inflationary eras, returning nearly 10% and more than 8% respectively, they plummeted in times of high inflation, the analysis showed.

That’s expected. Inflation weighs on earnings and profits as companies struggle to hike prices in line with rising costs, and tightening central bank policy slows the economy and makes borrowing more expensive.

Equity factor premiums, though, appeared uncorrelated to inflationary episodes. And when inflation was high, all the main factors except size earned a positive return.

“If you buy a quality or value portfolio, the additional return of that – historically – has been not tremendously different across the different inflationary episodes,” says Guido Baltussen, international head of quantitative strategies at Northern Trust.

Baltussen attributes the effect to enduring behavioural biases that create persistent mispricings in markets regardless of regime. That’s to say, whether prices are rising fast or falling slowly, investors still tend to chase performing stocks higher, fail to identify potential bargains, and so on.

In periods of moderate inflation, all the factors Northern Trust looked at – low risk, quality, momentum, the multifactor portfolio, value and size – beat the market, in that order. In mildly high inflation, momentum overtook low risk. In high inflationary regimes, quality outshone the rest, achieving a 3.3% real total return, or 5.1% on top of the market.

“At the individual factor level, quality does exceptionally well when inflation exceeds four percent,” Baltussen says.

That makes sense, he says, because quality firms offer strong profitability and are more conservatively managed. As such they have a buffer against continued pricing pressures, and are better able to maintain margins.

Quality’s usefulness when inflation is high has arguably been visible in recent years. Annual global inflation went from 5% to 8% and then to 3.6% from 2021 to 2023. Quality, alongside value, led the factor pack during that period, each with returns higher than 6%. Global equities returned about 1.3% annualised in real terms over the same three years.

The Northern Trust quants also looked at past episodes that matched current market conditions – high but decreasing inflation – including periods that ended with either a so-called hard landing, namely a recession, or a soft landing.

Hard landings brought double-digit negative returns both for markets and for factors. In both circumstances, though, quality did better than the rest.

“With interest rates or inflation shooting up again, whether you’re having a hard or soft landing, you do see that quality tends to do the best of all factors,” Baltussen says.

For those that trust history as a guide, then, the answer to the inflation question seems clear: buy quality.

Editing by Alex Krohn

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