01 Jul Factor Performance and Economic Regimes
- The value premium, in real terms, disappears when inflation is low.
- Low inflation, low growth periods have become more common.
Inflation and real economic output are frequently discussed when evaluating expected equity returns. Using these macroeconomic variables, we consider past factor performance.
Economic Regimes
Consider the four (4) regimes based on inflation and real output:
- “High Inflation” – high inflation, strong output
- “Stagflation” – high inflation, weak output
- “Deflation” – low inflation, weak output
- “Productivity Focus” – low inflation, strong output
Inflation is the growth rate of the Consumer Price Index (“CPI”) for all items followed in the U.S.1 Real output is the growth rate of the U.S. gross domestic product for the nonfarm business sector.2 Inflation and output comparisons are relative to their median values as of their measurement dates. This is most relevant when considering inflation – it increased ~1.0% from 1960 to 1980 and has steadily declined since then.
Since 1960, the most common experience for the U.S. has been Deflation followed by Stagflation.
The frequency of the deflation and stagflation events increased in 2000.
Figure 1. Cumulative Count for Economic Regimes, 1960 – 2020
The scatter plot illustrates that the common element was weak output.
Figure 1. Deflation and Stagflation, 1960 – 2020
Factor Premia Real Returns
Based on the factor premia from the Fama-French five-factor model, there is no performance trend among the factors and over the economic regimes.
As mentioned above, the U.S. has experienced Stagflation and Deflation most often. Real returns to factor premia were consistently negative during Stagflation, but returns were mixed in Deflation. The Value premium was non-existent during Deflation events.
Growth appears to outperform value to erode the value premium assuming Earnings Yield and Book-to-Price as proxies for Value.
Like Deflation, the Productivity Focus regime is characterized by low inflation. However, Productivity Focus has strong real output.
Figure 2. Productivity Focus and Deflation, 1960 – 2020
The value premium did not exist in real terms. Growth outperformed value, but real return to value was less robust than in Deflation.
Conclusion
Real return to the value premium was negative during Deflation and Stagflation regimes, the most common experiences in the U.S. During these periods, the value premium was negative due primarily to growth outperformance. The remaining factor premia failed to show consistent real return across economic regimes.
1 Organization for Economic Co-operation and Development, Consumer Price Index: Total All Items for the United States [CPALTT01USM657N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPALTT01USM657N, June 29, 2021.
2 U.S. Bureau of Labor Statistics, Nonfarm Business Sector: Real Output [PRS85006041], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PRS85006041, June 29, 2021.