Some economists and investors are convinced that after numerous false starts, inflation is finally ready for a resurgence. But a look at how individual sectors and groups perform when inflation expectations begin to rise offers up a surprise or two.
The chart at the top of the page from Jefferies breaks out which sectors tend to do best—and worst—when inflation expectations start to rise. During the last four trough-to-peak cycles for inflation expectations, the SP 500 SPX, -0.01% SPX, -0.01% has risen by a median 13%, while energy has outperformed by a median of 37%; materials and industrials have posted mid-single-digit relative returns.
Energy’s outperformance is no shocker. As noted by T.J. Thornton, head of U.S. product management at Jefferies, it could be that higher energy prices have driven past inflation, and that those higher energy prices are the reason energy outperforms.
But what about utilities, which are viewed as a defensive play and often as a proxy for bonds given their tendency to offer a steady stream of yields? Bonds and bond proxies are expected to suffer as inflation rises, sapping the value of yields. In that vein, real estate’s outperformance, though subdued, might also be viewed as a bit of a surprise.
Thornton emphasized that the chart is reflecting performance from the trough to peak of inflation expectations. Specifically, the chart is measuring performance over the course of the trough-to-peak move of the 12-month moving average of expectations as measured by the Conference Board.
Outperformance by utilities and real estate might be explained by the tendency of inflation to come later in the business cycle. In fact, during the later stages of an inflation cycle, the market might begin discounting an economic slowdown, which is good for defensives “all else equal,” he said.
Real estate might also benefit from being a hard asset, Thornton said, noting that many categories within the sector—hotels, self-storage, apartments—are able to adjust rents frequently enough to capture higher inflation.
Whether there will be a resurgence in inflation remains to be seen. Inflation expectations as measured by break-even rates, which are derived by looking at the difference between inflation-protected and nominal Treasury yields, have moved higher since the end of June.
But past upticks have failed to hold. And as Jefferies notes, the last definite trough in expectations as measured by the Conference Board survey was in July 2010, making the current slide in expectations “distinctly long” (see chart below).