Inflation Could Mean Value Stocks’ Time to Shine

Bitcoin, gold, oil, real estate—many assets are finding themselves on investors’ radar screens as concerns about inflation grow. The best refuge might be one that has been out of fashion for a while, though: boring old value stocks.

Value investing had a brief moment of superior performance early this year, only to sink back into second-class status as stocks like Tesla with triple-digit earnings multiples—and many with no earnings at all—surged anew. A broad basket of cheap stocks represented by the Russell 3000 Value Index has appreciated by a respectable 80% in the past five years. Russell’s corresponding basket of growth stocks has done more than 100 percentage points better, however.

Many people think of stocks of any stripe as a lousy investment when the cost of living surges, because the last time U.S. inflation was a major problem—from the late 1960s through the early 1980s—they went exactly nowhere and lost money in real terms. But companies with real assets, debts that are eroded by inflation and the ability to raise prices can do well and have done so at other times when inflation was elevated.

Even when they didn’t, value stocks were good relative performers. Decades like the 1940s, 1970s and 1980s saw value stocks beat growth amid fairly high inflation. By contrast, decades with low inflation or deflation such as the 2010s, 1930s and 1990s saw the opposite trend, according to data from researchers Eugene Fama and Kenneth French.

“It does feel like there is a shift,” says John Alberg, co-founder of Euclidean Technologies, which uses machine learning to manage long-term investments based on historical trends.

If inflation really is “transitory”—the result of supply-chain pressures that will soon reverse—then maybe growth can continue to trounce value for a while. But concerns about inflation have a way of becoming entrenched and turning into a persistent trend as companies succeed in pushing through price increases and workers demand higher pay. A search for “inflation” on media research site Factiva shows more hits in October, which isn’t yet over, than during any month in the past decade.

Companies that make electric cars, experimental drugs or software can raise prices, too, but their shares might be less desirable if inflation really picks up. The simple reason, Mr. Alberg surmises, is that when interest rates rise—as they tend to do during inflationary periods—the prospect of a payoff in the future is worth less than a more certain stream of cash in the near term.

Asset manager GMO recently opined on inflation hedges and found flaws with all of those now in fashion. Buying insurance backed by the full faith and credit of the U.S. Treasury through TIPS—bonds indexed to inflation—has become expensive.

So are industrial commodities, which cost money to store or to hold via financial instruments like futures. Traditional and newer havens like gold or bitcoin, meanwhile, have no intrinsic worth so they might or might not protect you. The best strategy, according to GMO, is to bet on a store of value in the form of cheap stocks.

“This is like being offered inflation insurance at a discount,” the asset manager said.

Note that this could merely mean a less-bad performance. Some decades when value stocks provided a haven and inflation was on the higher side, such as the 1980s, had stellar returns, but they started from a point when all stocks were a bargain. The cyclically adjusted price-to-earnings ratio maintained by Yale professor Robert Shiller was in the single digits in 1981. Today it is around 39 times—its highest level since shortly after the technology stock bubble burst 21 years ago and above the 1929 peak.

Value stocks might not be the most exciting inflation hedge, but havens rarely are.

The U.S. and Chinese governments should take action to lower future borrowing, as a surge in their debts threatens to have “profound” effects on the global economy and the interest rates paid by other countries, the International Monetary Fund said Wednesday.

In its twice-yearly report on government borrowing, the Fund said many rich countries have adopted measures that will lead to a reduction in their debts relative to the size of their economies, although not to the levels seen before the Covid-19 pandemic.

However, that is not true of the U.S. and China, which will continue to see a surge in borrowing if current policies remain in place. The Fund projected that U.S. government debt relative to economic output will rise by 70% by 2053, while Chinese debt will more than double by the same year.

The Fund said both countries will lead a rise in global government debt to 98.8% of economic output in 2029 from 93.2% in 2023. The U.K. and Italy are among the other big contributors to that increase.

“The increase will be led by some large economies, for example, China, Italy, the United Kingdom, and the United States, which critically need to take policy action to address fundamental imbalances between spending and revenues,” the IMF said.

The IMF expects U.S. government debt to be 133.9% of annual gross domestic product in 2029, up from 122.1% in 2023. And it expects China’s debt to rise to 110.1% of GDP by the same year from 83.6%.

The Fund said there had been “large fiscal slippages” in the U.S. during 2023, with government spending exceeding revenues by 8.8% of GDP, up from 4.1% in the previous year. It expects the budget deficit to exceed 6% over the medium term.

That level of borrowing is slowing progress toward reducing inflation, the Fund said, and may also increase the interest rates paid by other governments.

“Loose US fiscal policy could make the last mile of disinflation harder to achieve while exacerbating the debt burden,” the Fund said. “Further, global interest rate spillovers could contribute to tighter financial conditions, increasing risks elsewhere.”

A series of weak auctions for U.S. Treasurys are stoking investors’ concerns that markets will struggle to absorb an incoming rush of government debt. The government is poised to sell another $386 billion or so of bonds in May—an onslaught that Wall Street expects to continue no matter who wins November’s presidential election.

While analysts don’t expect those sales to fail, a sharp rise in U.S. bond yields would likely have consequences for borrowers around the world. The IMF estimated that a rise of one percentage point in U.S. yields leads to a matching rise for developing economies and an increase of 90 basis points in other rich countries.

“Long-term government bond yields in the United States remain elevated and sensitive to inflation developments and monetary policy decisions,” the Fund said. “This could lead to volatile financing conditions in other economies.”

China’s budget deficit fell to 7.1% of GDP in 2023 from 7.5% the previous year, but the IMF projects a steady pickup from this year to 7.9% in 2029. It warned that a slowdown in the world’s second largest economy “exacerbated by unintended fiscal tightening” would likely weaken growth elsewhere, and reduce aid flows that have become a significant source of funding for governments in Africa and Latin America.

An unusually large number of elections is likely to push government borrowing higher this year, the Fund said. It estimates that 88 economies or economic areas are set for significant votes, and that budget deficits tend to be 0.3% of GDP higher in election years than in other years.

“What makes this year different is not only the confluence of elections, but the fact that they will happen amid higher demand for public spending,” the Fund said. “The bias toward higher spending is shared across the political spectrum, indicating substantial challenges in gathering support for consolidation in the years ahead, and particularly in a key election year like 2024.”

Inflation Could Mean Value Stocks’ Time to Shine

Bitcoin, gold and oil are all having a moment, but the best haven might be value stocks.

Says U.S. and China, which will continue to see a surge in borrowing if current policies remain in place.