Positioning portfolios to tame the inflation beast

• Inflation is a key risk facing investors this year, as energy costs surge, a tight labour market puts upward pressure on wages, and supply constraints hinder industries’ response to rising demand for goods
• While December’s headline consumer price index (CPI) increased 7% year-on-year to a 40-year high in the US, inflation is expected to peak soon and fall in the second half of this year
• Inflation of between 2% and 4% tends to be the 'sweet spot' for asset class returns. Equities are among the assets that typically perform well in the upper end of this range
• If consumer prices remain high for a considerable period of time, commodities and inflation-linked bonds would likely play a key role in trying to limit the hit to returns from both equities and corporate bonds
• Despite the turbulence in financial markets, and inflation data, investors may be best served by focusing on their long-term goals and staying invested

Inflation is a key risk facing investors as many large economies loosen COVID-19 restrictions as energy prices surge and supply-chain disruptions hit attempts to meet a sharp shift in demand. Inflation expectations also seem to be on the up and feeding into pay. In the US, the Bureau of Labor Statistics’ employment cost index for civilian workers climbed 4% in the final quarter of 2021, year on year. The evidence is growing that the burst in inflation seen last year isn’t as transitory as many policymakers had expected.

How much longer is higher inflation here to stay?

The peak in inflation increases may be nearing. In December the headline consumer price index (CPI) rose 7%, on a year-on-year basis, hitting a 40-year high. That said, core inflation appears to have stabilised somewhat (being up by 0.5% in December, and compared with November). Indeed, the peak in year-on-year US inflation may come by March or April.

The CPI is likely to fall gradually over the course of the second half of the year. That said, it may not return to pre-pandemic levels, at least in the short or medium term. For instance, US inflation is expected to remain above 2.5% (and so the US Federal Reserve’s [Fed's] own target) by the end of this year.

However, some investors, and economists, expect inflation to be tougher to tame, anticipating prices to rise at an annual rate of at least 4% for the rest of this year or longer. Such a scenario would affect potential asset class returns and how investors choose to allocate within portfolios. 

Optimal asset allocation

Given the likely behaviour of asset classes to different regimes of inflation, the optimal asset allocation for portfolios under three potential scenarios for prices would be:

• If inflation moderates and settles slightly higher than seen over the past 10 years, equities should continue to outperform bonds, the latter still adding to portfolio performance. In this scenario, diversification matters. Other risk assets, including commodities, hedge funds, and private markets, can play an important role in maximising returns and limiting risks
• If inflation reverts to its pre-pandemic norms, commodities would likely underperform, while bond returns would probably jump considerably
• Finally, if elevated inflation takes root for several months, or years, there may be few places to hide. Commodities and inflation-linked bonds would likely help mitigate the expected hit to returns from both equities and credit instruments.

What about Fed policy?

With mandates to maintain price stability, the Fed, and other central banks, are turning more hawkish on the pace of interest rate hikes, to counter rising consumer prices. The Fed, which tends to pay particularly close attention to inflation expectations, is likely to lift rates in March.

It’s important to analyse the impact rate changes may have on equities and bonds. In looking to protect portfolios against the potential effects of higher inflation in such unusual times, investors might consider turning to what has been the most reliable source of returns over the long term: staying invested.