Stock ETFs for an Inflationary and Rising Rate Environment

When the US Consumer Price Index for All Urban Consumers (CPI-U) for March 2022 was reported in April, it was the first time in over 40 years that the index had increased by over 8% annually. It represents only the fifth period since January 1948 that this has happened. Moreover, annual inflation continued to be above 8% in the April CPI-U number announced in May 2022. The table below shows the other periods where the annual CPI increase has exceeded 8%.

Table 1: Periods Post 1948 with an Annual CPI Increase of >8%

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Energy prices have been the primary driver of recent inflation, with the gasoline index increasing annually by 48% in March 2022, although there was some relief in April with the index falling 6.1% over the month. However, inflation has been broad based, with the food index having increased by 8% annually in March and rising again in April 2022, the seventeenth consecutive monthly increase in this index. Items other than food and energy increased by 6.5% annually in March and rose again in April, driven by increasing rents and a sharp rise in airline fares.

How long inflation will be sustained remains unclear since the 50 basis point Fed Funds rate hike announced on May 4, 2022, will likely be followed by additional 50 basis point hikes this year and multiple quarter point hikes through the end of 2023. This is likely to be accompanied by other forms of quantitative tightening. However, at least for now, U.S. consumers and investors appear to be entering an unusual inflationary period, since the median annual CPI increase over the last 74 years has been 2.8%.

Investor Response to Rising Rates

In an environment marked by inflation and rising rates, investors will need to assess how to rebalance their portfolios. Analysis by Sam Stovall, CFRA’s Chief Investment Strategist, shows that as of end-April 2022, the S&P 500’s 12.4% year-to-date (YTD) decline was the deepest selloff during that calendar period since WWII, and history says, but does not guarantee, that the market may continue to be challenged, since the S&P 500 rose only 30% of the time in May following the 10 worst YTD-April declines.

Typically, during periods of inflation and rising rates, investors may adopt a range of strategies. One strategy is to invest in commodities and REITs since ‘real assets’ tend to be viewed as an inflation hedge. Another is to rotate into shorter duration bonds since they typically tend to outperform longer dated bonds during periods of rising rates.

Within the equity sleeve of their portfolios, investors will want to stay invested but potentially rotate into strategies that may perform better in this environment. In the past, investors would have had to analyze and construct such portfolios themselves. In the last few years, however, there have been a few specialized equity ETFs launched that are designed for inflationary and rising rate environments.

Stock ETFs for Inflationary Conditions

Two equity ETFs designed for inflationary conditions are the Fidelity Stocks for Inflation ETF (FCPI) and the Horizon Kinetics Inflation Beneficiaries ETF (INFL). FCPI gives investors an index-linked option priced at a competitive 0.29%. It tracks the Fidelity Stocks for Inflation Factor index, which has large- and mid-cap U.S. constituent stocks that the index provider believes has the potential to outperform in inflationary conditions. The index is designed relative to the broader market as measured by the Russell 1000 index and is overweight those sectors that benefit from inflation like energy, materials, healthcare, consumer staples, and real estate. The ETF is currently rated 5 stars by CFRA due to its high scores on both the risk and reward parameters in CFRA’s quantitative ETF rating system.

INFL gives investors an actively managed option, although at a higher cost of 0.85%. This ETF also scores high on both CFRA’s reward and risk dimensions and has an overall 4-star rating in CFRA’s model due to its slightly lower score on the cost parameter.

Table 2: Stock-Based ETFs in the U.S. Intended for Inflationary Environments

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In terms of their constituent holdings, these two ETFs take very different approaches. As of May 9, 2022, INFL had the largest exposure to the materials (26%), financials (26%), and energy (23%) sectors. It held energy stocks like Viper Energy (VNOM NR) and PrairieSky Royalty (PSK NR) as well as consumer staples like Archer Daniel Midlands (ADM) and Bunge Limited (BG). It also held materials stocks like Franco-Nevada (FNV) and Glencore (GLEN) as well as trading-oriented financials stocks like the Intercontinental Exchange (ICE), ASX Limited (ASX NR) and Deutsche Boerse (DB1).

In the same period, FCPI had a much higher weight in the technology (21%), healthcare (18%), and consumer staples (11%) sectors. It is important to examine this ETF in relation to the broader market since its sector allocation is designed relative to the Russell 1000 index. It is overweight by 5% in the energy, materials, healthcare, consumer staples, and real estate sectors relative to the broader U.S. equity market and underweight in sectors like IT and financials. As of May 9, 2022, the two largest holdings in FCPI were technology stocks Apple (APPL) (5%) and Microsoft (MSFT) (4.3%), with the ETF also holding healthcare stocks like UnitedHealth (UNH) (2.4%), Pfizer (PFE) (1.8%) and Anthem (ANTM )(1.6%).

Figure 1: Sector Comparison Between FCPI and INFL

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Source: CFRA ETF database; sponsor websites. As of May 9, 2022.

Stock ETFs for Rising Rate Conditions

There are also two equity ETFs listed in the U.S. designed specifically for rising rate conditions, both of which are index linked. The ProShares Equities For Rising Rates ETF (EQRR) is linked to a Nasdaq index designed to track sectors and stocks within those sectors that have a high correlation to 10-year U.S. treasury yields. The Fidelity Dividend ETF for Rising Rates (FDRR) holds large- and mid-cap dividend payors that also have a positive correlation to 10-year U.S. treasury yields.

Table 3: Stock-Based ETFs in the U.S. Intended for Inflationary Environments

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These two ETFs also have significant differences in GICS industry exposure. As of May 9, 2022, EQRR was more heavily concentrated in financials (32%), energy (28%), and materials (22%). Some of the largest holdings were energy stocks like Valero Energy (VLO ***) (3.4%) and Marathon Petroleum (MRO ***) (3.1%) as well as financials like M&T Bank (MTB ***) (3%) and JP Morgan Chase (JPM ***) (2.8%).

The holdings of FDRR are spread across a larger number of sectors and the ETF rebalances annually to a sector neutral profile. As of May 9, 2022, IT was the largest sector (27%), and it also had >10% exposure to the healthcare, consumer discretionary, and financials sectors (see Figure 2).

Figure 2: Sector Comparison Between EQRR and FDRR

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Source: CFRA ETF database; sponsor websites. As of May 9, 2022.

Looking Ahead

Throughout 2022, the CPI-U and the Fed Funds rate will be very closely watched indicators to gauge the environment facing investors. If inflation persists despite rising rates and quantitative tightening, investors will likely explore different strategies. For their equity exposure, investors are likely to consider stock-based ETFs that are specifically designed for an environment of inflation and rising rates.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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