Protecting investments from the detrimental effects of inflation is an important issue for investors, with the burst of inflation from 2021 to 2024 a reminder. So, how does the investor find investments with less sensitivity to inflation? Bonds priced with a fixed payout are quite sensitivity to inflation, so the investor might turn to equities. In selecting equities, the screen seems simple: Seek out firms which can readily adjust selling prices without loss of customers (that is, they can increase revenues with inflation) while experiencing relatively a low increase in expenses. And beware of firms with significant debt assets (available-for-sale and thus marked to fair value) relative to debt liabilities. However, the issue is a little more complicated. Revenues are affected by the demand from downstream customers, and these can be businesses who are impacted negatively by inflation. And so for upstream suppliers affected.
A recent paper develops an industry-level estimator they call the “Weighted Production Price Index” (WPPI) score. The goal of the WPPI is to succinctly summarize the net effect of inflation shocks across all industries on a given focal industry. For each industry-month, the WPPI score weights the vector of industry-level Purchasing Poer Index (PPI), where the weights are determined by the historical relationship between returns of that industry and the cross-section of industry PPI indices. The WPPI differs from an industry’s PPI. An industry’s PPI is a variable reported by the U.S. Bureau of Labor and Statistics and represents the weighted-average of monthly price changes in that industry. An industry’s WPPI is a comprehensive measure that reflects the effect of all price changes across all industries on the stock returns of the firms in that industry. Each industry-month WPPI encapsulates the composite inflationary effect of monthly price changes across all industries on the firms in a given industry. An industry or a firm that receives a high (low) monthly WPPI score has just experienced positive (negative) inflationary news.
We have not worked with it, but it is worth a look. The paper documents a strong correlation between WPPI and contemporaneous earnings (ROE or ROA) in the cross-section, more than twice as high as that between PPI and same-quarter earnings. Similarly, WPPI has a stronger correlation with contemporaneous industry returns than own-industry PPI. The paper also reports that WPPI has strong predictive power for cross-sectional industry-level and firm-level returns, while own-industry PPI does not. In out-of-sample tests, an industry-level WPPI-based strategy that buys recent inflation winners and shorts recent inflation losers yields in a seven-factor alpha of 1% per month.
See Feng, J., S. Huang, C. Lee, and Y. Song. 2024. Inflation in the Cross-section: Separating Winners from Losers. At https://www.ssrn.com/abstract=4907871.