Could extra diversification take the sting out of inflation?

Inflation may only be one factor when it comes to investing but underestimating its damaging effects can blow a hole in your expected returns.

And as we’ve seen in the past few months, inflation is running hot – and it’s expected to remain at these elevated levels, or higher, for some months to come.

Historically, high inflation has been trouble for bonds. Equity valuations can be hit as well. While persistent high inflation can also start to influence stocks and bonds similarly – and, if they start to move in tandem – what does that mean for the traditional 60/40 equity-bond portfolio if everything’s correlated and nothing acts as a ballast to ride out market bumps?

In order to prepare for different scenarios over the next 12 months, we investigate the inflation outlook and which asset classes might best shield portfolios in an inflationary world.

Inflation prospects

It’s our view that the powerful forces that kept inflation low in the 2010s – ageing populations, suppressed commodity prices, technological changes, and reduced production costs due to globalisation – will bring inflation under control once again.

Therefore, our baseline scenario is that the inflation rise is only transitory, and it’s expected to fade away in the short-to-medium term. However, there are several risks that may yet materialise, and keep inflation elevated for some time.

Geopolitical tensions and trade wars might resurface and offset some of the benefits of globalisation. Government debt is also at historically high levels, and it’s possible central banks will take a more flexible view of inflation over the short-to-medium term as any interest-rate hikes will increase the cost of national borrowing. 

Inflation could also result from the transition to a greener economy – so-called “greenflation” – as fighting climate risk and reducing environmental footprints is likely to incur higher costs.

Higher labour costs associated with wage increases, and costs associated with investments in equality and diversity, could also be another factor driving inflation.

The potency of commodities as an inflation hedge

Commodities are typically the best hedge against upside inflation surprises (see Figure 2), with energy and industrial metals outperforming when there is an unexpected spike in inflation. This is to be expected, as these commodity sub-sectors are the key inputs in the industrial production process.

Precious metals can also be used as an upside inflation hedge. And although they do not perform as strongly as energy when inflation spikes, they are one of the best choices among commodities as a downside-inflation hedge. This is a reason why gold is considered as one of the best portfolio diversifiers.

The convenience of inflation-linked bonds

On an asset class level, inflation-linked bonds (ILBs) represent the second-best inflation hedge. This is unsurprising as ILBs, by design, automatically adjust in a rising inflation environment. 

However, it’s important to consider break-even inflation as well, which represents the market-implied future inflation rate.

Short duration might help nominal bonds

On average, nominal bonds are under pressure when inflation spikes because interest rates tend to rise in parallel.

However, losses can be controlled to an extent by overweighting shorter duration bonds in a portfolio, irrespective of their credit risk exposure. Nominal government bonds also tend to provide protection if inflation surprises on the downside. 

Stocks that can thrive in periods of high inflation

Investing in stocks provides a direct growth exposure. In the case of rising inflation, companies should be able to pass on higher costs to consumers.

But in practice, this process changes at a different pace for each industry. To gain further insight into how equities react to bouts of unexpected inflation, we extended our analysis to investing styles.

Our results are intuitive – growth and momentum stocks provide the best protection against upside inflation surprises. Quality stocks are neutral to inflation spikes, whereas value, high-dividend and low volatility stocks do not provide protection in strong inflationary scenarios.

In a strong deflationary scenario, none of the equity styles provides protection. This is because such events typically coincide with an economic recession when there’s a usually a sell-off in equities.  

Aiming to shield your portfolio from inflation

Therefore, to deal with inflation surprises, one potential solution could be a diversified multi-asset class portfolio including commodities, inflation-linked bonds, selected equity styles, and shorter duration bonds.

Diversification has always been the bedrock of a long-term investment process. But crafting portfolios that are resilient and robust in different macroeconomic environments requires careful consideration of key systematic risks.

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