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#Market Strategy — 17.01.2018

Equities: Inflation and Sector Rotation

Guillaume Duchesne

A return to inflation in 2018 is a real question mark. Who will benefit from it? Who will be penalised on the equity markets?

In 2017, equity markets fully benefited from low inflation and an acceleration in economic growth. A major question being debated today in the markets is the potential return of inflationary pressure, particularly in the United States. There are several possible reasons for this scenario: solid global growth, possible wage increases in some countries (returning to the famous Phillips curve), rising producer prices in China, and a sustained high oil price. Inflationary pressure could intensify further especially as the economic recovery is synchronised between the different geographical (emerging and developed) regions.

In this context, what would be the impact on the various industries? What are the potential sector rotations on equity markets?    

The analysis of correlations over the last five years between sector performance and two key economic indicators—inflation and a leading indicator (PMI)— has provided a clear indication of the behaviour of different industries in relation to the economic environment. Cyclical stocks usually benefit from rising inflation and higher economic growth. Typically, materials and capital goods are the main beneficiaries. Their revenues increase in a context of strong growth. Financials too benefit from a rise in nominal interest rates and—in the context of higher economic growth forecasts—the steepening of the yield curve (the profitability of financial institutions improves when the spread between long and short rates is greater). Conversely, defensive sectors (consumer staples, real estate, telecoms) which sometimes offer high and often stable dividends, suffer from a reflationary environment and should be favoured in the event of deflation (declining prices) and/or a recession (contraction of business activity).

In conclusion, any inflationary pressure in a climate of sustained economic growth could persuade investors to use a sector rotation strategy in favour of cyclical and financial stocks. This rotation could be rapid given the significant valuation differentials between sectors at present. Indeed, some sectors—growth stocks in particular— have been massively played out and are now trading at multiples which are deemed as high.