In previous editions, we have argued that the impact of changing inflation on stocks depends on the initial level of inflation and the direction of travel.

The combination that tends to be most favorable for stock markets is when inflation is rising from very low levels (and deflation risks are receding) or when high inflation levels are moderating. As the chart shows, for stocks, bonds, and balanced funds, higher inflation (above, say, 3%) that is rising tends to be the worst outcome, while inflation above 3% that is falling is much more benign. For stocks in particular, the best returns tend to occur when inflation is below 1% but rising; this is often associated with a recovery from a recession and also with a decline in the risk of deflation (and is therefore not particularly favorable for bond markets).

Stable returns with inflation within range: reversal of extremes tends to be bullish

However, as we showed earlier in the PMIs, there has been a significant increase in the price of PMI inputs in recent months, and these pressures could eventually spread to overall consumer price inflation. In addition, many companies that have reported Q1 2021 results have been mentioning inflationary pressures.

So the question that follows is: what would happen if we moved from "higher temporary inflation" (base scenario) to higher persistent inflation, say around 3% (risk scenario)?

First, duration should be shortened further and bonds reallocated to commodities and equities. Commodity indices (such as the S&P GSCI) are perhaps the most direct inflation hedge. Commodities are also cheap in a historical context: they are the only major asset classes that declined in absolute terms over the past decade (the underperformance is significant and largely due to falling energy prices). Since 2010, the S&P 500 has quadrupled, while the S&P GSCI index has declined by nearly 40%.

Among stocks, buy value and a low-volatility short style. Growth and quality also have a negative correlation with inflation.

The expectation of higher rates is lifting "value" stocks that are cheap relative to current earnings and can therefore be considered short-duration. Meanwhile, "growth" stocks that are expensive relative to current earnings and are therefore long-duration are struggling in relative terms. In this environment, the financial sector can provide a hedge against a sharp rise in long-term rates, while commodities offer a hedge against higher inflation.