The relationship between inflation and small-cap premiums and evaluating small-cap stocks as a hedge to inflation for G7 countries

Inflation erodes personal wealth, and portfolio managers must seek inflation hedging strategies to mitigate this risk. Small-caps stocks have been shown to react more negatively to macroeconomic shocks than large caps and a better understanding of this effect on small-cap returns can have important implications for portfolio management decisions. This paper studies the effect of inflation shocks on G7 small-cap premiums as well as the regime-dependent relationship of premiums with inflation and default risk. This paper also studies the long-run hedging properties of small-cap and large-cap stocks against inflation risk in G7 countries from 1994 to 2022 by estimating their Fisher Elasticities through univariate and panel analysis. Markov Switching regression shows that the variation in the small-cap premium can be explained by inflation and default risk factor regimes under weak and strong economic regimes. Cross-sectionally dependent panel cointegration analysis shows that G7 country large-cap and small-cap stocks are effective hedges against inflation in the long run in the post-GFC period. These results have important implications for building effective hedging strategies based on the market capitalization of publicly traded companies in the G7