What inflation could mean for ETFs

Between labor shortages and a spiking consumer price index—which measures changes in prices over time—hedge funds, pension funds, and other large investors are keeping a close eye on what these indicators mean for the bottom lines of companies they’re investing in.

Inflation “is the number one concern among institutional investors,” says Rebecca Corbin, CEO of Corbin Advisors, whose research on institutional investor sentiment shows that 69% of institutional investors expect inflation to continue to rise in the second half of this year.

Just as it impacts a broader portfolio, inflation influences exchange-traded funds, or ETFs. Those securities follow various investment strategies, such as closely tracking indexes, following broader markets, or homing in on exposure to specific sectors or asset classes. iShares, asset manager BlackRock’s ETF business, released a quarterly guide on its rest-of-year outlook for the exchange-traded market. Here’s what you need to know:

The impact of inflation could be long-lasting

If you’re expecting prices to go back down soon, you may be disappointed, according to Gargi Pal Chaudhuri, head of iShares’ investment strategy in the Americas, who wrote about her anticipation for long-lasting inflation in the recent iShares 2021 outlook guide.

While Jerome Powell, chairman of the Federal Reserve, has said rising inflation isn’t permanent, institutional investors tend to believe that the effects of inflation may take months or quarters to settle, according to Corbin.

“This inflation is across every element of goods and services,” she says. “That doesn’t just evaporate overnight; it has to work its way through the system.”

Inflation will likely be longer-lasting than the last global economic recovery, iShares’ Chaudhuri writes. That’s because of the backdrop of economic growth, sustained fiscal and monetary policy support, higher production costs, and supply-chain diversification during the pandemic. 

The good news? Value and small-cap stocks have performed well in the first half of this year because of the economic growth. In particular, cyclical ETFs, whose performance is closely tied to the success of the broader economy, have attracted $53 billion more in inflows than those in the defensive sector, which are meant to balance risk and stay stable during market downturns, according to iShares.

When inflation goes up, fixed-income yields suffer, as the purchasing power of the dollar goes down. iShares anticipates that bond yields will move “moderately higher,” but the ETF manager is not expecting much in terms of returns. The asset manager says it is favoring short-duration Treasury Inflation-Protected Securities (TIPS) and bonds linked to floating rates. Short-duration ETFs listed in the U.S. have attracted $7.7 billion in inflows thus far in 2021, according to iShares. 

Quality over cyclic stocks

While the global economic boom may be sustainable, financial markets are hard to predict, and they don’t always cooperate with broader economic trends—as seen during the pandemic.

BlackRock’s iShares holds the position that it’s time to tilt portfolios toward companies with high return on equity, stable year-over-year earnings growth, and low financial leverage, known as “quality” stocks, rather than focus on ones whose prices tend to fluctuate based on broader economic trends (known as “cyclic” stocks or funds). These positions may be preferable and guard against rising input, labor, and financing costs—as well as potential corporate tax hikes.

“We see the potential for quality’s performance to improve as the economic cycle evolves, investors anticipate more normalized growth, and potentially become cautious about taxes, inflation, and the timing of a Federal Reserve policy shift,” Chaudhuri wrote in the outlook.

There has been about $1.7 billion in inflows to global quality ETFs in the second quarter of this year, according to iShares, which says it is particularly bullish on the technology sector.