How to ride out the inflation storm

• Rampant inflation in many developed markets is likely to drive the pace of interest rate hikes – which could affect financial market performance in the coming months
• But history offers little guidance on where inflation is heading, with many recent price hikes pandemic related. Nevertheless, we forecast that inflation will settle in a range that is slightly higher than its 10-year average – and expect equities to outperform bonds
• Other asset classes, such as hedge commodities, hedge funds, and private markets, could also play an important role in maximising returns while limiting risk at a time of elevated prices
• Yet, with more surprises expected in how economies and markets react to the pandemic, staying invested for the long term – and with a fully-diversified portfolio – still seems the most prudent option

When we published our Outlook 2022 in November, we listed the top five risks investors should monitor. Inflation was number one. At that time, wage pressures were still muted, but since then they have increased. In the US, the Bureau of Labor Statistics’ employment cost index for civilian workers was up 4% in the fourth quarter, year on year. This stickier component of the inflation basket suggests that the recent burst in inflation isn’t as transitory as may have been thought.

Equally, to this point, there is no reason to believe that the US consumer price index (CPI) will continue to climb. In December, the headline CPI increased 7% year-on-year, a 40-year high¹. Energy costs were a key contributor, as oil and gas prices soared compared to a year ago.

When stripping out these volatile components, and looking at the month- on-month trend, core inflation appears to have stabilised somewhat (+0.5% in December, stable versus November). Our view remains that we may see the peak in year-on-year US inflation by March or April.

How much of a risk is inflation?

After peaking, we would expect inflation to “normalise” gradually. Normalising does not mean returning to pre-pandemic levels, at least not in the short or medium term. Similarly, gradually means that this process will take quarters and not months. In fact, we expect US inflation to still be above 2.5% (and therefore the US Federal Reserve’s (Fed) own target) by the end of this year.

Some investors have a much more aggressive view on inflation, expecting prices to rise at an annual rate of at least 4% for the rest of this year or longer. Obviously, if such a scenario occurs, it would have significant implications for investors. With that in mind, we looked at various inflation regimes and what it means for various asset classes.

What does this mean for investors?

Unfortunately, looking at past data isn’t necessarily a great indication for what a period of elevated inflation might mean for investors in the aftermath of a pandemic. The last time CPI was above 7% in the US was in the early 1980s.

However, this was at that time when inflation was moderating, having peaked at more than 14% in 1980. Similarly, the US Fed funds rate jumped as high as 20% in 1981 compared to 0.25% at the time of writing.

In addition, the world is a very different place compared to 40 years ago: the worldwide web was still being developed; IBM, AT&T, and Exxon were the biggest components of the S&P 500 index; and China exported goods worth around 6% of its gross domestic product, compared to 18% today.

Yet, history is the only hard data that forecasters can rely on to try and form views about the future. With that in mind, after looking at how various asset classes tend to respond to inflation surprises, we have looked at inflation’s dynamics over the last 20 years and how inflation has impacted returns across classes. Our analysis shows that:

• With inflation, like with any other trend, the starting point matters: a 4% CPI rate has different implications if the starting point was 1% or 7%
• There is a “sweet spot” for inflation. Anything too high (above 4%) or too low (such as in deflationary eras) narrows the universe of investments likely to generate positive returns
• Real and riskier assets tend to do better in periods when inflation is in the upper-range of this sweet spot (or between 2% and 4%).

The asset classes suited to different inflation scenarios

Given the typical reaction of various asset classes to inflation, we look at the optimal asset allocation for portfolios under three different scenarios for prices (see table):

• If, as we expect, inflation moderates and settles in a slightly higher range than experienced over the past 10 years, equities should continue to outperform bonds, with the latter still contributing positively to performance. In this scenario, diversification is key. Other asset classes, including commodities, hedge funds and private markets can play an important role in maximising returns and limiting risks
• If, on the other hand, inflation was to revert to pre-pandemic levels, commodities would likely underperform, with fixed income returns likely to jump substantially
• Finally, if like many investors fear, inflation remains elevated for an extended period of time, there may be few places to hide. Commodities and inflation-linked bonds would then play a key role in trying to mitigate the pressure on returns from both equities and credit instruments.

The influence of central bank policy and inflation expectations

Of course, any change in inflation does not happen in a vacuum. With mandates to maintain price stability, central banks may respond to changing consumer prices by tweaking interest rates. They will be particularly attentive to inflation expectations. This is why we assessed whether these expectations have become unanchored.

In addition, as central banks’ main policy tool to influence inflation remains interest rates, we believe it’s important to analyse the impact rate changes may have on, and within, both equities and fixed income markets.

While adjustments can be made to portfolios, in order to prepare for or protect against higher inflation, the reality is that current circumstances are unique, and historical playbooks may be inappropriate this time around. In such unusual times, investors may simply want to turn to what has been the most reliable source of returns over the long term: staying invested.