Inflation is up 8.6% in the last year (data as of May 2022), as measured by the Consumer Price Index (CPI)—a level not seen since 1981, and more than four times the Fed’s inflation target of 2%. That’s translating into higher costs for everything from groceries to gasoline and other everyday essentials.

Though there are many factors that can contribute to inflation, most experts agree our current bout is being caused primarily due to four main issues: 

• Rising energy prices, partially due to the ongoing war between Russia and Ukraine (but also due to public policy and the lack of investment in adding new capacity)

• Rising labor costs, due to a tight labor market

• Increased consumer demand, driven by a strong job market (so far) and, for many Americans, a higher level of savings during the COVID-19 pandemic

• Supply chain disruptions, caused by lockdowns in China paired with increased consumer demand

In an effort to get inflation back under control, the Federal Reserve (because it cannot increase the supply of goods or services) has raised interest rates in an attempt to cool off consumer demand and soften the labor market.  

While this may help rein in inflation, it also brings with it a new set of challenges for investors. That’s because rising interest rates tend to have a negative impact on many sectors of the stock market (as well as bonds). It’s also important to acknowledge that some fear the Fed’s rate hikes could prove to be too aggressive and trigger a broader recession.

The good news, however, is that inflation does not impact all equity sectors alike. In fact, some sectors of the stock market actually perform better during periods of high inflation such as the one we find ourselves in right now. With this in mind, allocating a portion of your investment portfolio to these sectors may help you hedge against inflation and boost returns despite general market malaise.

Stock Market Sectors: A Quick Overview

While most people tend to speak of the stock market as a collective whole, the truth is that it actually consists of a number of different sectors—high-level groupings of companies based on the different areas of the economy that they operate within. 

Different sectors tend to perform differently depending on the economic cycle, so knowing how these sectors perform can help an investor diversify and position their portfolio for any number of different scenarios.

The stock market can be divided into 11 major sectors:

1. Energy 

2. Materials

3. Industrials

4. Consumer Discretionary

5. Consumer Staples

6. Healthcare

7. Financials

8. Technology

9. Communications

10. Utilities

11. Real Estate

Each of these sectors can be further divided into industries and sub-industries. 

For example, precious metals and mining are often broken out as a subsector of the materials sector. Likewise, equity real estate investment trusts (REITs) and mortgage REITs each form distinct subsectors within the broader real estate sector.

Best Sectors for Inflation

Below, we provide a high-level overview of three stock sectors that have historically performed well during periods of high inflation. We also discuss the potential reasons that these sectors tend to outperform others when inflation is high.

1. Energy

What it is: The energy sector of the stock market is primarily focused on companies that are engaged in the exploration, production, refinement, marketing, storing, and transportation of consumable fuels. This typically includes oil, natural gas, ethanol, and coal, as well as other fuels. Companies that produce equipment, machinery, technology, materials, and services that support these activities are also often included in the sector.

The 5 largest names in the sector: Exxon Mobil, Chevron, Royal Dutch Shell, ConocoPhillips, and Linde are the five largest publicly-traded companies in the energy sector as of October 18, 2022.

Why it performs well: Energy, especially in the forms of oil, gas, and electricity (often produced by coal) is a necessity regardless of the underlying market environment. Consumers will continue to buy energy even if prices rise—not because they want to, but because they have to. This insulates many energy companies from the pressures faced by other, more “elective” expenses.

2. Equity REITs

What it is: Equity REITs are companies that own and manage physical real estate, which they use to generate income—often, by collecting rent from tenants. This income is then passed on to investors in the form of distributions known as dividends. By law, REITs must pass along at least 90% of their net earnings to investors. REITs may focus on buying a particular type of real estate (such as retail space, single-family homes, data centers, etc.) or may diversify their holdings.

The 5 largest names in the sector: Prologis, American Tower, Crown Castle, Public Storage, and Equinix are the five largest publicly-traded companies in the equity REIT sector as of October 18, 2022.

Why it performs well: Real estate is often viewed as a hedge against inflation. That’s because real estate values and rents charged by landlords typically increase when inflation is high. For investors, these increases translate into higher dividend payments. 

3. Metals & Mining

What it is: The metals and mining sector of the stock market includes companies involved in the exploration, production, refinement, and sale of metals. This can include precious metals such as gold, platinum, and silver, as well as industrial metals like aluminum, copper, and steel and rare earth metals necessary for many electronics. Technically, this is a subsector within the broader materials sector.

The 5 largest names in the sector: BHP Group, Rio Tinto, DowDuPont, Vale, and Air Products and Chemicals are the five largest publicly-traded companies in the metals & mining sector as of October 18, 2022.

Why it performs well: Companies in the metals & mining sector can perform well during periods of high inflation, due to a number of factors. One such factor is the inclusion of gold in the sector, which is seen by many as an effective inflation hedge. Another factor is that industrial metals such as copper and steel are, to some extent, a necessity regardless of the economic environment. This means that metals and mining companies can often pass along the costs of higher inflation to the end customer through higher prices. 

That being said, metals and mining companies outperform inflation less consistently compared to the energy and equity REIT sectors discussed above. According to research compiled by Hartford Funds, the sector has returned an average real return of 8% during periods of high and rising inflation, but only beat inflation roughly 50% of the time. By comparison, the energy and equity REITs sectors have outperformed inflation roughly 70% of the time.

Worst Sectors for Inflation

For comparison, below are three sectors that have historically underperformed during periods of high inflation.

1. Consumer Discretionary

What it is: The consumer discretionary sector includes industries and businesses that produce or provide non-essential products and services enjoyed by consumers. This is directly opposed to the consumer staples sector, which produces products and services deemed to be everyday essentials. Companies operating in the hotel, restaurant, high-end apparel, entertainment, luxury, and travel industries are often included in the consumer discretionary sector. The sector is also sometimes called the consumer cyclical sector.

The 5 largest names in the sector: Walt Disney, Nike, Comcast, Netflix, and Sony are the five largest publicly-traded companies in the consumer discretionary sector as of October 18, 2022.

Why it performs poorly: The consumer discretionary sector is extremely sensitive to economic cycles and periods of high inflation. Because the products and services provided by companies in this sector are generally viewed as “nice to have” and not "essential", they are often among the first expenses removed from an individual’s budget when prices for essentials rise. This lowered demand is typically translated into lower corporate earnings and, therefore, lower share prices.

2. Technology

What it is: The technology sector of the stock market, also called the IT sector, includes a wide swath of companies that sell goods or services related to computers, electronics, software, artificial intelligence (AI), and general information technology. This may include both consumer goods, such as mobile phones, home appliances, televisions, and personal computers, as well as goods and services that businesses need to be effective.

The 5 largest names in the sector: Apple, Microsoft, Alphabet (Google), Meta (Facebook), and Taiwan Semiconductor Manufacturing are the five largest publicly-traded companies in the technology sector as of October 18, 2022.

Why it performs poorly: The technology sector has historically performed poorly during periods of high inflation. One reason for this is the fact that, while there are exceptions, the technology sector includes many companies that are growing very quickly, but which are not yet profitable. These companies (and other growth companies) tend to perform well when investors have fewer options for yield. But when interest rates rise, it typically causes bonds and other fixed income investments to increase their yield. This makes fixed income investments more attractive, and tends to cause an outflow from the technology sector.

Additionally, high inflation eats away at the value of the potential future earnings that these companies might enjoy, making their growth less valuable over time. Of course, the largest technology companies, with high bargaining power, can often raise prices to negate the negative impact inflation has on profits. 

3. Mortgage REITs

What it is: Like equity REITs, mortgage REITs form a subsector within the broader real estate category. Also like equity REITs, mortgage REITs must pass on at least 90 percent of their net earnings each year to investors in the form of dividends. There are important differences, however. While equity REITs earn income by directly owning and managing real estate, mortgage REITS lend money to real estate owners and operators. They make their money from the interest payments on those loans, instead of through direct rent payments.  

The 5 largest names in the sector: Annaly Capital Management, Starwood Property Trust, AGNC Investment Corp, Blackstone Mortgage Trust, and Arbor Realty Trust are the five largest publicly-traded companies in the mortgage REIT sector as of October 18, 2022.

Why it performs poorly: Unlike equity REITs, which tend to outperform during periods of high inflation, mortgage REITs often perform poorly due to the effect that rising inflation has on interest rates. That’s because rising rates tend to squeeze a mortgage REIT’s profit margin, reducing its overall earnings and giving it less of an income to distribute to shareholders. While most mortgage REITs hedge against interest rate risk using a variety of strategies, sudden changes to interest rates (as we have been seeing lately) can be difficult to hedge against.

Diversification and Your Portfolio

It may be tempting to read the discussion above and go all-in on the sectors which tend to outperform during periods of high inflation. 

But most experts would agree that that would likely be a mistake. Most investors would instead benefit by embracing a well-diversified portfolio that considers the global macro environment and contains exposure to these assets alongside other sectors that may benefit from any economic recovery that takes place, if and when inflation is brought under control. 

Here at Allio, we understand the impact that rising inflation and interest rates can have on investors’ returns. We’ve leveraged that understanding and expertise to design investment portfolios that take prevailing macroeconomic conditions into consideration.