Inflation’s High And Falling: These Sectors Should Rise

Stocks aren’t exactly a one-size-fits-all proposition: shares from different sectors respond differently to changes in inflation and the overall economy. And if you understand those differences, you can strategize accordingly.

Luckily, Morgan Stanley has crunched the numbers, looking at the average annualized performance in excess of the market in different inflationary environments from 2000 to 2019, and put the results in this chart. Here’s what you need to know:

When inflation’s below trend but climbing – think “early business cycle vibes” when economic growth is on the upswing and interest rates are low and steady – stocks tend to dazzle. This is prime time for cyclical sectors that get a jolt from inflation, like energy and materials. But don’t forget about consumer discretionary, industrials, and tech – they also ride high on that strong demand wave.

When inflation’s above trend and keeps rising, it’s like the economy’s on a caffeine buzz – it’s all too strong, too fast. To chill things out, central banks often have to step in and hike interest rates. This cool-down move isn’t great for rate-sensitive sectors like utilities and real estate. Safer bets like consumer staples underperform most, as investors chase more adrenaline-pumping options. In this turbo-charged environment, energy and tech sectors surf the high waves.

When inflation’s above trend but falling, it’s a hint we’re at the later stages of the cycle, with the economy already laying on the brakes. In these less-rosy times, defensive players like consumer staples, healthcare, and utilities start to lead the pack. Real estate also gets a boost as interest rates dip. But tech stocks, which are usually market darlings, often fall behind here – likely because profit forecasts begin to dim and investor mood turns a bit gloomy.

When inflation dips below the trendline and keeps dropping, it’s usually a sign we’re in the “recession” zone of the cycle. Around this time, central banks start slashing rates, all in a bid to jumpstart the economy and keep the job market running. At this point, you’re best to avoid energy stocks – they’ll be feeling the pinch from both the slowdown and falling prices. On the flip side, utilities will be soaking up the benefits of both the economic lull and the rate cuts. And this, my friends, is the moment for defensive sectors like healthcare and consumer staples to shine.

Mind you, the chart shows “average” returns and the framework is just a simplification of the economic cycle. But it’s a useful one: if you think inflation is falling and will keep falling – meaning we’re in the third stage and moving to the fourth – then you might want to consider owning sectors like consumer staples, healthcare, utilities, and even real estate. They may help you position your portfolio for a more difficult environment – particularly if it’s already heavy in tech stocks.