- Inflation doesn't necessarily imply negative or even below-average returns for stocks.
- Sectors have performed quite differently under inflationary regimes.
- Energy stocks have been positively correlated to inflation during periods of rising prices.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
A lot of investors are thinking about inflation and the potential impact on stocks right now. Last week, I wrote about how the situation in jobs and housing may reflect some transitory and structural inflation. Given this inflation expectation, it got me thinking about which sectors have performed best during periods of rising prices historically. The clear answer was energy stocks.
Inflation in context
In addition to the 1940s and 1970s, there were 2 additional, but much smaller, inflation waves over the past few decades, as measured by swings in the 5-year compound annual growth rate (CAGR) of inflation. The first was 1987-1992 and the second was 2003-2008. The following chart shows these 4 inflation regimes.
The next chart shows the S&P 500 real return during those inflation regimes. The long-term CAGR for the inflation-adjusted S&P 500 is 6.82% (since 1926). We see here that, except for the 1970s, the stock market has actually done OK during inflation regimes, at least compared to its long-term trend.
Historically, the P/E ratio for stocks is inversely correlated to inflation, generally speaking. But that doesn't necessarily translate to negative or below-average returns. It all depends on the starting point and what happens on the "E" side of the P/E ratio.
My guess is that most people would just assume that inflation regimes are uniformly bad for equity returns, using the 1970's as the obvious example. The data says otherwise.
And by the way, did you notice that these structural inflation waves tend to occur in cycles of around 9 years on average? 1942-1950, 1965-1980, 1987-1992, 2003-2008, 2020-?. On that basis alone, we could be due for another wave.
Sectors amid inflation
So which sectors win and lose during inflation waves? The following chart shows the correlation of monthly relative returns against the monthly inflation rate for the 11 sectors. The message is fairly consistent: Energy sector relative returns have been positively correlated to inflation every single time, while consumer discretionary and financials have been negatively correlated every single time.
Relative performance to inflation for sectors has been a bit less consistent, however. Energy is still the most consistent relative winner, but consumer and financial stocks are a bit more mixed. The starting and end point matter a lot when calculating CAGRs, so that's a nuance worth keeping in mind.
Of course, there's no guarantee that the trends of the past will play out in the future. Moreover, markets may remain sensitive to lingering macroeconomic trends that have the potential to change quickly—the COVID-19 pandemic, global supply chain disruptions, and worries of an energy crisis, to name a few.
With that said, if inflation does heat up and history is any indicator, you may want to keep your eye on those sectors that have historically performed well when prices are rising.