A spoonful of factors helps inflation go down
The analysis by Dutch investment giant, Robeco, shows bonds and equities in general have delivered positive nominal and real returns during periods of modest inflation and deflation recorded since 1875.
However, the study concludes that factor tilts deliver reliable premiums above standard asset class-based allocations through all periods regardless of the inflation backdrop.
“Splitting up inflationary regimes into sub-regimes reveals that stagflationary episodes, inflationary bear markets or rising inflationary times, and to a lesser extent deflationary bear markets, are bad times for investors,” the paper says.
“During these ‘bad times’, equity, bond, and global factor premiums are consistent and attractive, as they are across inflationary regimes. As such factors help to alleviate the pain during bad times, offsetting some of the negative impact of high inflation.”
Guido Baltussen, Robeco head of factor investing, says periods of ‘stagflation’ – or low growth coupled with high inflation – have proven particularly harsh for vanilla bond and share portfolios.
“During these stagflationary intervals, bonds delivered a nominal return of 5.1 per cent, but a real return of -4.4 per cent 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 per cent and -11.7 per cent, respectively,” Baltussen says.
“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 per cent and 4.7 per cent, 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.”
But tilting bond and share portfolios to factors such as value, momentum or quality can only take the edge off losses in high inflationary times rather than offer full protection.
“These [factor] premiums provide diversification, but at the same time are also not a perfect hedge against inflation, as their returns do not substantially increase during the worst times,” the paper says. “Finally, our results suggest factor premiums in equities, bonds, and across asset classes are not a compensation for bearing inflationary risks.”
Authored by Baltussen along with Robeco colleagues, Laurens Swinkels and Pim van Vliet, the ‘Investing in deflation, inflation, and stagflation regimes’ used a range of data sources to map out inflationary periods dating back to 1875.
“We choose to exclude these hyperinflation periods as they are very rare and special episodes that come with large measurement noise and risks for investors that they typically choose to exclude,” the report says.
Given few investors today have experienced either high inflation or deflation, the study says the historical record provides valuable insights into “how risk premiums and investment strategies behave across inflationary regimes like periods of high inflation, deflation, or stagflation”.