BlackRock: 3 equity investing ideas amid higher rates and inflation

This article was originally published on blackrock.com by BlackRock Fundamental Equities.

After steep year-to-date declines across the major U.S. stock averages, investors from BlackRock Fundamental Equities believe individual company fundamentals will once again emerge as the key differentiator and driver of outcomes. The upshot: an opportunity for stock pickers to apply their company-level research and analysis to separate potential winners and losers.

One caveat is that this is likely to occur within a new regime. As we discuss in our latest market outlook, the Fed is intent on raising interest rates to fight inflation and must balance the risk that creates for economic growth. In the end, we expect the world to look different from the low-rate, tame-inflation environment that had prevailed since the Global Financial Crisis (GFC) of 2008.

Against this backdrop, investors may want to consider revisiting their portfolios with a focus on three key elements that we believe are well-suited to the new order taking shape.

1) Value investing

Value stocks have a history of outperforming their growth counterparts in times of rising rates and inflation. This is because the cash flows of value companies are front-end loaded. Growth stocks, in contrast, are considered longer-duration assets with expectations of greater cash flows further into the future. These farther-off cash flows get discounted by higher rates, giving value stocks an upper hand in an inflating environment.

In a BlackRock Fundamental Equities analysis of growth versus value stocks using data since 1927, we found value had achieved greatest outperformance in periods of moderate to high inflation. It was only when inflation was very low that value performance paled. Value stocks have also tended to perform well amid rising interest rates. Over the past 40 years, a sizable portion of value returns has come during periods of rising rates, as shown below.

A strong showing as rates rise

Value returns amid rising vs. falling rates, 1978-2020

Source: BlackRock, with data from Compustat/IBES, Dec. 31, 1978-Dec. 31, 2020. Chart shows the annualized return of the cheapest stocks (Quintile 1) minus the most expensive (Quintile 5) as ranked by our proprietary value factor. Returns are aggregated for rising and falling interest rate periods. Monthly changes in the 10-year U.S. Treasury yield are used to define rising and falling interest rate periods.

2) Quality investing

Stocks have historically performed well versus bonds during Fed rate-hiking episodes. In the case of bonds, the inverse relationship between price and yield means their prices fall as rates rise. For stocks, the positive impact of earnings has historically outweighed the drag that higher rates apply to valuations, as shown in the chart below.

Earnings make a difference

Breakdown of stock performance in prior rate-hiking cycles, 1994-2018 Sources: Datastream Worldscope, Haver Analytics and Goldman Sachs Investment Research, February 2022. Chart shows the performance of the MSCI AC World Index between the first Fed rate hike and the next time the Fed cut rates in any given period. Performance is divided into the contribution from valuations and company earnings. The technology, media and telecom (TMT) sector is excluded from the 1999-2000 period because of the distorting impact of the dot.com crash. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. For illustrative purposes only.

That said, we do expect further equity market volatility as investors adjust to the new regime, and companies will weather the storm with varying degrees of agility and success. We believe the key to navigating this environment is to focus on companies with quality characteristics ― particularly strong balance sheets and healthy free cash flow.

We see present-day cash flows and earnings growth as critical performance drivers in this new environment ― and believe well-managed, quality companies can provide greater stability, growth and income potential to withstand inflation and market volatility.

3) Natural resources and commodities exposure

When inflation is high, the best-performing assets are often those tied to basic needs. Food, transportation, electricity and shelter are the foundation of modern civilization, and commodities and natural resources equities can offer investors exposure to these building blocks.

Commodity prices show a higher correlation to inflation than other asset classes in a relationship that is self-reinforcing: Rising commodity prices tend to drive higher inflation which, in turn, propels higher commodity prices. Applying an equity lens, we find that the performance of natural resources equities is driven largely by commodity prices. It follows then that in periods of rising inflation, natural resources equities have delivered strong relative returns.

Investors are focused on inflation

Inflation surfaced as the perceived greatest risk to equity markets over the next six months in a BlackRock Fundamental Equities survey of more than 1,000 U.S. investors ― ahead of geopolitics, Fed policy and COVID-19 resurgence.*

We do not see inflation sustaining at the current decades-high level over the long term, but we do expect it will settle into a range above the sub-2% seen in the aftermath of the GFC.

Taking constructive steps to position for the new investing regime can help prepare portfolios for the moment when deep uncertainty begins to give way to greater clarity.