Fighting inflation with equity duration: three fundamentals to look for

Each month, we get more news about how rising prices are eating into our wallets, whether it’s June’s 8.1% inflation rate in Canada or the 9.1% rate in the U.S. But inflation is also detrimental to investors, their portfolios, and their plans for retirement. So, what can they do to combat it?

The threat of rising inflation and resulting interest rate hikes has sent markets spiraling into bear market territory. Though we’re of the view that core inflation should taper off for the remainder of the year, investors are likely facing a new inflation reality in the long run—one that’s a few notches above the 2% or so we’ve seen over the last decades. If this is the case, investors should be asking how they can protect their portfolio. Our answer to this challenge starts with equity duration.

What is equity duration?

As bond investors should know, duration is a measure of the weighted average of each cash flow that’s due to be received over the life of the bond. The lower the duration, the sooner the investor is theoretically repaid on an investment. It’s also a measure of the sensitivity of the bond’s price to changes in interest rates: the higher the duration, the more the bond price changes as rates change.

This same concept can be extended to equities. Equity duration can be thought of as a measure of how long an investor must receive dividends in order to be repaid the purchase price of the stock. Since cash flows are weighted by their present value, equity duration—like bond duration—can also be a measure of how sensitive the stock price is to changes in interest rates.1 Equity duration is key to understanding how to invest for inflationary times.

 

Inflation fighters: three key fundamentals

Why is equity duration management important in the context of an inflationary environment? First, moving into stocks with lower durations could be part of a strategy to lower overall portfolio volatility, as research suggests that lower duration stocks tend to be less volatile than higher duration ones. Moreover, with inflation on the rise, interest rates are rising as well. In a persistently rising rate environment, low-duration stocks would, by definition, outperform high-duration stocks (all other things being equal).

With the information that low duration can be key to fighting inflationary and rising rate environments, what characteristics should you look for if seeking low-duration equities? We believe that inflation-fighting equities come with three key characteristics.

High and growing dividends

One way to lower equity duration and, thereby, fight inflation is to target dividend payers. Part of the reason is the simple argument that a bird the hand is worth two in the bush. In a world where purchasing power is decreasing rapidly, having dividends in one’s portfolio removes the uncertainty associated with waiting for dividends in the far-dated future. Dividends are also a major source of total returns—going back over a century, they’ve provided nearly half of the total return of the S&P 500 Index. 

Dividends are a critical component of total return

Sources of S&P 500 Index annualized total return by decade

Bar chart of the sources of S&P 500 return split between price return and dividend return by decade. It shows that dividends are an important source of overall returns.

Source: Manulife Investment Management calculations using Robert Schiller Data Library from 1909 to 1989 and Bloomberg from 1989 to December 31, 2019. It is not possible to invest in the index. Past performance is not a guarantee of future returns.

But finding quality dividend-paying companies that can help lower your duration profile goes beyond just looking at a dividend yield figure. It’s critical to dig deeper to find companies that are generating strong cash flow—as opposed to looking only at profits or at earnings before interest, taxes, depreciation, and amortization (EBITDA) measures—which can be manipulated. Only companies that are generating real-world cash flows can be counted on to distribute those flows in the form of dividends. Also bear in mind that there’s a difference between high cash flows and dividends, and growing cash flows and dividends. Certainly it’s nice to have a high dividend, but for long-term investors, we prefer an approach that focuses on companies that are growing their cash flows and dividends; the ability to consistently grow cash flows and distribute them in the form of dividends over long periods is a testament to these companies’ ability to withstand rocky economic times and deliver value to investors. Indeed, it’s no surprise that during inflationary periods, the S&P 500 Dividend Aristocrats Index has outperformed the broader S&P 500.

High quality dividend stocks have outperformed in inflationary times

1-year forward return during periods of inflation since 1990

bar chart of the 1-year forward return of the S&P 500 and S&P 500 Dividend aritsocracts index during periods of inflation since 1990. Dividend aristocrats have outperformed in every inflationary period studied.

Source: Bloomberg, Manulife Investment Management, Capital Market Strategy, as of April 30, 2022. Indices are unmanaged and can’t be purchased directly by investors. Past performance isn’t indicative of future results. Performance in USD.

High return on equity

Second, return on equity (ROE) can be a great tool to qualify a low-duration company. ROE is an excellent gauge of the money-making power of a business. By comparing the three pillars of corporate management—profitability, asset management, and financial leverage (debt)—ROE tells an investor a lot about the effectiveness of a company's executive team and the overall strength of its business.

A high return on equity is a great indicator of a company that’s efficiently using the capital of its shareholders, making it high quality and likely able to continue generating cash flows. This is important since it’s a sign that the company is self-funding, meaning it’s less likely to have to go to market to raise debt or equity—something that’s particularly costly in an environment of rising rates and bear equity markets.

In short, a company that can efficiently turn its capital into revenues and profits is one that’s likely to have a better profitability profile, higher cash flows, and overall lower duration.

 

Low price-earnings multiples

Finally, price-earnings (P/E) multiples are a key fundamental to watch in times like this. With both the Bank of Canada and the U.S. Federal Reserve (not to mention other central banks around the world) raising rates to combat inflation—in additional to other measures—financial conditions are tightening. This doesn’t bode well for stocks with high P/E multiples.

Why so? From a logical perspective, stocks with high P/Es (that is, growth-oriented stocks) are generally less profitable and cash-flow positive than stocks with lower P/Es (value-oriented stocks). In other words, cash flows, and thus dividends, are more likely to flow to investors further into the future than for stocks with low P/Es, thereby increasing equity duration. Furthermore, growth names also rely more on debt financing, and with rates on the rise, it’s going to become more expensive for these companies to borrow.

The relationship between P/E and rising rates can be seen historically as well. The last few decades suggest that when financial conditions tighten (for example, when interest rates are rising), P/E multiples contract—particularly when conditions tighten quickly, as we’ve seen in the last few months. The Chicago Fed’s National Financial Conditions Index bounced off its June 2021 low, rising to –0.15 in July 2022, indicating that financial conditions have been tightening.2 In that same timeframe, S&P 500 forward P/E multiples have contracted from 21.4 to 15.8. If history is any indication and if rates continue to rise as the market is expecting, equities with high P/E multiples could be in for a rough ride.

When financial conditions tighten, P/Es contract

S&P 500 forward P/E vs. financial conditions

Line chart of the S&P 500 forward P/E multiple against the Chicago Fed's national financial conditions index. It shows that when financial conditions tighten, P/Es contract

Source: Macrobond, Federal Reserve Bank of Chicago, Manulife Investment Management, as of July 27, 2022. Positive values of the NFCI indicate tighter-than-average financial conditions; negative indicate looser-than-average financial conditions. 

Three tools to help fight inflation

Fighting the devastating effects that inflation can have on portfolios is no easy task, and certainly there’s no one solution. But by targeting companies that are paying and growing dividends, are using their capital efficiently, and have lower price-earnings multiples, we’re confident that investors can build portfolios capable of withstanding rocky markets and inflationary times.

 

 

1 Although there’s no generally accepted formula for equity duration as there is for bond duration, the concept for both is similar, with the caveat that dividend payments aren’t nearly as certain as a bond’s coupon payments are, hence the lack of consensus on how to calculate equity duration. 2 For the National Financial Conditions Index, values below 0 indicate looser-than-average financial conditions, while values above 0 indicate tighter-than-average, so a rising number indicates tightening financial conditions.

The opinions expressed are those of Manulife Investment Management, as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.

All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Unless otherwise specified, all data is sourced from Manulife Investment Management.

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Robert Wernic

Robert Wernic, 

Director of ETFs

Manulife Investment Management

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