Inflation and sector returns - Investors can exploit the differences

The impact of inflation on equity markets is not uniform. Theory suggests that equities should be neutral to inflation but reality is different. Without going through all of the reasons, sectors will have significant differences in inflation sensitivities. There are also different responses between inflation sensitivity levels and inflation surprises. These differences allow for construction of inflation sensitive and insensitive portfolios based on the inflation forecasts of investors or their desire to hedge inflation risk.

One of the broad factors for equity sensitivity is the level and acceleration of inflation, and currently we are in the worst market conditions, inflation greater than 3% and rising. The equity response to inflation is non-linear. In the current environment, the chance of the rolling 12 month return being positive is slightly less than a flip of a coin. Nevertheless, sector performance allows for portfolio tilts that will create some inflation protection.