Inflation and Individual Equities

Andrew Ang, Marie Brière and Ombretta Signori

Financial Analysts Journal, 2012, vol. 68, issue 4, 36-55

Abstract: Since 1990, stocks with strong inflation-hedging abilities have had higher average returns than stocks with low inflation betas and have tended to be drawn from the technology and oil/gas sectors. The authors found substantial time variation among stock inflation betas, which makes it difficult to construct portfolios from stocks that are strong out-of-sample inflation hedges. This finding holds for sector portfolios, portfolios constructed on past-inflation betas, and portfolios constructed from high-dividend-paying stocks. We studied whether portfolios of individual stocks can adequately hedge inflation risk. Although the poor inflation-hedging ability of the aggregate stock market has long been documented, the literature has focused on the behavior of aggregate stock market indices. But there is considerable heterogeneity in how individual stock returns covary with inflation. Different companies have different pricing power. Constructing portfolios on the basis of individual stocks has the potential to provide a much better inflation hedge than the aggregate market.To measure the inflation-hedging ability of individual stocks, we computed stock-level inflation betas. We grouped stocks into portfolios on the basis of inflation betas for the full sample, which allowed us to conduct both an ex post analysis of which companies provided the strongest realized covariation between stock returns and inflation and a tradable out-of-sample analysis in which the portfolios were constructed by using information available only at the beginning of each month.We found substantial variation in how individual stocks covary with inflation. Although the correlation of the aggregate market with inflation is negative (the average inflation beta of S&P 500 Index stocks was –0.52), there is a significant subset of stocks with high and significantly positive inflation betas over the sample. Since the 1990s, the top 20 stocks with the highest realized-inflation betas have had inflation betas exceeding 5. The quintile portfolio with the highest ex post inflation betas overweighted oil/gas, which benefits from rising commodity prices, and technology, a sector in which the products of many companies command premium prices owing to technological innovation. The remaining quintile portfolios had negative inflation betas. Thus, a non-negligible subset of stocks has covaried positively with inflation. Moreover, stocks that have been good inflation hedges have had, on average, high nominal and real returns.However, trying to forecast ex ante inflation betas at the individual stock level is not easy. The inflation betas exhibit pronounced time variation. Up to 20% of stocks, on average, exhibit sign changes in inflation betas from year to year. The large amount of time variation in inflation betas at the individual stock level makes it hard to construct portfolios of stocks that have good inflation-hedging ability on an ex ante basis. The cross-sectional dispersion of inflation betas also varies over time. During the recent financial crisis, the inflation betas for many stocks changed signs, going from negative before 2008 to positive over 2008–2009. The substantial variation in stock inflation betas makes it difficult to find stocks that are good out-of-sample inflation hedges. This is true not only for portfolios constructed on past-inflation betas but also for sector portfolios and portfolios constructed from high-dividend-paying stocks

Date: 2012
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DOI: 10.2469/faj.v68.n4.3

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