Until recently, inflation wasn’t a serious or persistent economic problem. In developed markets, it hovered around 2% for the past 30 years. Investors became accustomed to low and stable inflation in which real returns were close to nominal ones. However, the COVID-19 crisis caused an unprecedented increase in money creation and extraordinary expansionary fiscal spending in most developed markets, which led to heightened concerns about inflation risks. Thus, in developing portfolios, it's helpful for today’s investors to understand how risk strategies performed during different inflation/deflation regimes.
To address that issue, in their November 2022 study “Investing in Deflation, Inflation, and Stagflation Regimes,” Robeco’s Guido Baltussen, Laurens Swinkels, Bart van Vliet and Pim van Vliet examined asset class and factor premiums across inflationary regimes in key developed markets over periods starting as early as 1875 and ending in 2021. The investment factor premiums they examined were: value (dividend yield or book-to-market), momentum (past 12 months minus the most recent month), low risk, quality (50% profitability/50% investment) or carry (depending on the asset class) applied in three markets: equities, bonds and across global markets. They divided their sample into four global inflation regimes: (1) below 0%, or deflation, (2) between 0% and the current central bank target of 2%, (3) a mild inflation overshoot, between 2% and 4%, and (4) high inflation, above 4%. Each regime represented about 20% to 30% of the observations. Here is a summary of their key findings:
Over the period 1875 to 2021, there were 23 years of deflation and 46 years of inflation above 4%. The median value of annual inflation equaled 2.3% for global markets and 2.2% for the U.S. At the 10th percentile, there was deflation of -1.4% and -2.4%, respectively. At the 90th percentile, there was inflation of 8.9% and 7.2%. The global equity return averaged 8.4% (in arithmetic terms) between 1875 and 2021; the global bond market return (currency risk hedged) was 4.5%; and global inflation averaged 3.2%.
Asset Class Premiums During the Four Inflationary Regimes
Asset class premiums varied significantly across inflationary regimes in both nominal and real terms.
Moderate inflation scenarios provided the highest returns across asset class and factor premiums, as the real return on the 60/40 multiasset portfolio was 7.2% and 5.6% per annum (p.a.) for the 0 to 2% and 2% to 4% inflation buckets—positive but low consumer price increases are good for nominal and real investment returns.
During deflationary periods, nominal returns were low, but real returns were attractive. Deflationary expansions were relatively good for investors, with a 10.4% real return p.a. for the 60/40 portfolio, while deflationary recessions were slightly positive (1.6%) in nominal terms but better in real terms (4.9%).
The four equity factors showed strong and statistically significant performance over the long-run sample, with average returns ranging from 2.5% (quality) to 6.9% (momentum). Low risk had the highest t-stat (6.7). The overall multifactor equity (MFE) strategy, constructed as a 1/N combination of the individual factors available each period, provided a robust and significant outperformance; the average return was 5.1% with a high t-value of 7.4; it was economically and statistically significant in all subsamples and was 4.1% over the most recent 30 years. The combination of value and momentum provided the most consistent results, benefiting from their negative correlation.
During high-inflation regimes, real equity and bond returns were negative, especially during times of stagflation, with nominal equity returns averaging -7.1% p.a., yielding double-digit negative returns in real terms. During these bad times, equity, bond and global factor premiums were consistently positive, providing diversification benefits. The factor benefits held during periods of recession, falling earnings growth and falling equity markets.
Factor Premiums in High Inflation
Equity, bond and global factor premiums were generally consistently positive across high inflation regimes, displaying generally no significant variation, while enhancing nominal and real asset class returns in long-only asset class portfolios—factor performance did not seem to depend much on the level of inflation, as the multifactor portfolio returned 5.9% in deflation, 5.3% in inflationary periods, and 5.1% and 4.5% when inflation was just below or above 2%.
The value factor was the weakest stand-alone (while diversifying well to the other factors, especially momentum) but performed relatively well during inflationary periods when conventional asset classes did poorly. On the other hand, quality/carry performed slightly worse during inflationary times, but better in each of the other inflationary regimes. Low risk performed well, especially in the extremes (deflationary or inflationary regimes) and was weaker in the middle two that were Goldilocks scenarios for equities and bonds. Momentum performed consistently and well across the inflationary regimes.
Impact of Interest Rates
Increasing interest rates caused more pain (-6.8% real return p.a.) to a conventional multiasset portfolio than decreasing interest rates (2.2% real return p.a.), as both equities and bonds suffered in real terms (-6.0% and -8.0% p.a., respectively).
During decreasing rate periods, equities and bonds experienced materially better real returns (3.9% and -0.3% p.a., respectively), while average returns on factor premiums were good across subregimes, but generally a bit better when rates increased (especially momentum in equities; trend following stood out during these episodes, while low risk in equities and value in bonds benefited more from declining rates in times of inflation).
The following table shows the long-run evidence, over the full sample period of 147 years and three subperiods, on asset class and factor premiums.
The following table shows the investment returns for the asset classes and factors during the four inflation regimes.
Ultimately, Baltussen, Swinkels, van Vliet and van Vliet concluded: “Investors who are, for example, worried about achieving negative real returns during stagflation periods may improve their asset allocation by including factors across asset classes. This would help their portfolio to a certain extent from these adversary business cycle conditions.” They added: “For both bear and bull equity markets in times of inflation, a diversified portfolio of factor premiums yields robust performance enhancements, thereby alleviating the pain of high inflation. Again, all factor premiums yield positive returns, except for momentum in bonds and low risk across assets during high inflation bear markets.” Summarizing, they stated: “Overall, we can conclude that the most severe bad times for investors in traditional asset classes are times of high inflation with either economic or earnings downturns, rising rates, falling equity markets, or rising inflation, or deflationary bear markets, and factor premiums on average help to alleviate the pain during these periods.”
These findings on the diversification benefits of factor strategies are consistent with those of Maria Kartsakli and Felix Schlumpf, authors of the 2018 paper “Tail Behavior in Portfolio Optimization for Equity Style Factors,” who examined the performance of the five Fama-French factors (market beta, size, value, investment and profitability)—as well as momentum—to determine how they behaved in the tail of their distribution. The authors concluded: “Our results indicate that Fama-French factors offer diversification benefits during periods when market experiences losses. As a consequence, they comprise a useful source of information when we wish to optimize the asset allocation of our portfolio.”
Baltussen, Swinkels, van Vliet and van Vliet’s findings also are generally consistent with those of Henry Neville, Teun Draaisma, Ben Funnell, Campbell Harvey and Otto Van Hemert, authors of the study “The Best Strategies for Inflationary Times,” published in the August 2021 issue of The Journal of Portfolio Management, covering the shorter period beginning in 1926.
Investor Takeaways
Baltussen, Swinkels, van Vliet and van Vliet showed that adding factor exposures to traditional portfolios can significantly reduce tail risk while also enhancing efficiency by providing the diversification benefits of adding unique sources of risk: “Asset class and factor premiums are strong and consistent ‘empirical facts,’ with attractive significant average returns over time.” Their evidence demonstrates that, while not a perfect hedge against inflation, factor premiums provide diversification benefits that are especially valuable in bad times.
Investors have realized clear diversification benefits from adding exposure to well-documented factors such as value, profitability and momentum. There also is another benefit—since these factors have demonstrated premiums that are persistent, pervasive, robust to various definitions, implementable and have intuitive risk- or behavioral-based explanations for why you should expect them to continue to generate a premium, adding exposure to them allows investors to hold less exposure to market beta (because the equities you do hold have higher expected returns). This freedom allows you to diversify your portfolio across more unique factors, creating more risk parity.
Finally, a word of caution. It is important for investors to understand that factor series are all long-short factors that do not include trading costs, and investors need to implement factor exposures in efficient ways to exploit the benefits of factor strategies in practice.
Larry Swedroe has authored or co-authored 18 books on investing. His latest is Your Essential Guide to Sustainable Investing. All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice. LSR-22-422