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Can investing in global equities help beat inflation in 2022?

4 January 2022 in Investing, Investment themes

Most of us crave simplicity. In the context of inflation and financial markets, it would be wonderful to say, “if inflation is x%, investors should buy this; if inflation is y%, they should buy that.” Unfortunately, in the real world, things are not that simple and the best course of action from a financial perspective depends on a multitude of factors, of which the inflation rate is just one part.

As well as your personal situation, what also matters is whether inflation is going up, or down; what are the expectations for inflation in the future; is any increase likely to be temporary? What is the level of interest rates, and will central banks adjust them? If so, how quickly? Is economic growth weak or strong?

Ultimately, the world is a profoundly different place from the last time inflation stood at current levels. But by understanding the historic relationship between investing in global equities and inflation, you may feel better equipped to navigate the current uncertainty around rising inflation.

This article suggests some key questions investors should ask to better understand the link between inflation and the performance of equities – and why we think investing in global equities will be a key investment theme in 2022 to protect against inflation.

Can investing in global equities provide a buffer against inflation?

The first and most important point is that global equity markets have historically offered the best opportunity for delivering real (after inflation) returns over the long term versus other major asset classes, such as bonds, commodities or cash.

However, the data also suggests that global equities may offer better protection from inflation than other major asset classes over shorter periods.

Below, we show the five-year rolling returns of global equities, UK government bonds (also known as gilts) and cash in real terms (after UK inflation). The graph demonstrates that exposure to global equity markets has provided the best opportunity to deliver real, positive returns over this short period. The worst outcome – in financial terms – came from keeping cash in the bank.

Past performance is not a reliable indicator of future performance.

How do global equity investments keep up with inflation?

One of the reasons why investing in global equities can act as a buffer against the effects of inflation is because there is a positive relationship between company earnings and inflation - meaning that company earnings generally rise (and fall) as inflation does. This is because many companies have the ability to increase their prices during inflationary periods to maintain earnings.

To demonstrate this, the graph below shows the relationship between US inflation and US company earnings growth over the last 20 years. We can see company earnings per share (EPS)* have generally followed a similar trajectory as inflation.

US inflation and earnings growth (year on year % growth)

How does inflation impact global equity valuations?

While equities have generally shielded portfolios against inflation, the situation is not entirely straightforward. We also know that higher rates of inflation generally have a dampening effect on equity valuations (which are ultimately a calculation of future earnings at today’s interest rate).

Inflation is not the sole determinant and other factors, such as interest rates, profitability and growth forecasts also have a bearing. But in broad terms, the higher the inflation rate, the lower the valuation level, measured by the price earnings ratio or P/E*, at which a stock market will tend to trade.

Average S&P 500 trailing p/e by Consumer Price Index (CPI) y.o.y tranche (1950 - current)

To demonstrate, using US equity market data since the 1950s in the graph above, we can conclude that when inflation has averaged between 0% and 2%, the S&P 500 has traded on an average price-earnings (P/E) ratio* of 18.6 times. When inflation has averaged between 6% and 8%, this multiple falls to an average of 10.9 times.

This is important for investors because lower valuations possibly indicate lower future returns.

Which global equity sectors have beaten inflation in the past?

While past performance is not necessarily a reliable indicator of future performance, you might reasonably ask what sort of company investors might want to hold if inflation settles at a higher level than it has averaged over the past 30-years.

In general terms, the best companies to own will be those which have pricing power - the ability to pass on any cost increases to their customers. Companies with a clear competitive advantage should also fare well, while a low and stable cost base and the ability to benefit from greater automation are also useful attributes in an inflationary environment. Ultimately, companies that can maintain and increase their margins are likely to be rewarded.

From a sector perspective, again using historical S&P 500 data, it has been the defensive sectors, particularly consumer staples (essential consumer purchases such as food, beverages and household goods) which have performed best when inflation is rising.

In contrast, technology, consumer discretionary (non-essential consumer purchases) and real estate stocks have shown a negative correlation with inflation (underperformance when inflation is rising and vice versa). However, the historic correlations are not strong – reminding investors that inflation is not the only factor to be considered.

S&P 500 sector correlation to core Consumer Price Index (CPI) (year on year % change, 1990 - current)

Have large-cap equities or small-cap equities historically performed best against inflation?

If we are looking for a particular style and size of company that offers the opportunity to outpace inflation, we would highlight that US small-cap value companies[1] are the only asset class in the US to have outperformed US inflation in every decade going back to the 1930s. Small-cap growth companies[2] have fared well in general, but underperformed in the 1970s and 2000s.

US small cap growth and value stocks v US inflation (CAGR %)

How to invest in global equities

At Canaccord, we are a specialist wealth manager with a deep heritage and expertise in investing in equities from around the world. As we consider our investment themes for 2022, we believe that a focus on the inflation credentials within equity selection will remain important and, therefore, we are likely to maintain our long-standing exposure to US companies and those which can demonstrate pricing power.

Meanwhile, we have recently introduced a robotics and automation theme to our discretionary client portfolios, which was partly predicated on our belief that companies will target greater automation to try to safeguard themselves against the burden of inflation in the future. This is something which may further strengthen the case for equities in 2022.

* Earnings per share (EPS): an indicator of a company’s profitability, it is the portion of profit after tax allocated to each outstanding share in issue.

* Price earnings (P/E) ratio is the share price divided by the EPS. For historic periods the average share price for the year is used; for forecast years, the current share price is used. It shows how much investors are willing to pay per dollar of earnings.

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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

This is not a recommendation to invest or disinvest in any of the companies, themes or sectors mentioned. They are included for illustrative purposes only.

The information contained herein is based on materials and sources deemed to be reliable; however, Canaccord Genuity Wealth Management makes no representation or warranty, either express or implied, to the accuracy, completeness or reliability of this information. Canaccord is not liable for the content and accuracy of the opinions and information provided by external contributors. All stated opinions and estimates in this article are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information.


[1] Value stocks are stocks which investors believe have been undervalued by the market and are trading for less than their intrinsic worth. They are viewed as trading at a lower price than
justified when measured against metrics such as earnings, profit margins or sales.

 
[2] Companies that are expected to deliver better than average organic revenue and earnings growth over the medium term.

Photo of Justin Oliver

Justin Oliver

Chief Investment Officer, Canaccord Genuity Funds

Justin provides direct assistance to the Chief Investment Officer in maintaining responsibility for the investment philosophy, process and methodology of Canaccord Genuity Wealth Management, and acts as the alternate to the CIO. He is Chairman of Canaccord Genuity Wealth Management’s Portfolio Construction Committee, a member of the Asset Allocation and Fund Selection committees and manages several of Canaccord Genuity Wealth Management’s Select range of funds. Justin is a Chartered Fellow of the CISI and is a former President of the Guernsey Branch of the Institute.


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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.

Investment involves risk and is not suitable for everyone.