Chart in Focus: Can quality hedge against inflation?

Inflation fears for 2025 are back, especially after Trump's election. Key policies and robust growth could lead to unexpected inflation, and in turn, different implications on investment returns. As such, understanding inflation and interest rates is crucial.

Since 2001, during periods of inflation over 3%, higher-quality stocks and bonds outperformed, suggesting that moving up in quality during such periods may benefit portfolios.

Quality stocks (high return on equity, low leverage, stable earnings) are more resilient. Higher inflation increases credit risk in fixed income, with default risk rising down the quality spectrum.

Figure 1

Investment implications

• Historically, quality stocks outperform in both high and low inflation environments, offering upside if inflation persists and limited downside if it abates.
• Quality stocks seek to be defensive in bear markets, but "Magnificent 7" companies still have heavy weights in quality indices, exposing them to concentration risk should mega caps downturn.
• Fixed income outcomes depend on inflation. Rate cuts help lower-quality issuers as inflation eases but are more vulnerable should inflation increase.

What we are watching

• US inflation drivers: Monitoring economic data and Trump administration policies that could trigger unexpected inflation.
• Central bank rate paths: The US Federal Reserve may not normalize rates quickly if Trump enacts his policies. Sustained rates or surprise hikes could increase borrowing costs and defaults.
• Defensive/quality sector developments: AI investment and mega caps, deregulation and health care, environmental policy and utilities.