Building inflation-resilient portfolios

Assessing inflation in interesting times

Predicting inflation under normal circumstances is hard enough. The worldwide uncertainty surrounding COVID vaccines and variants, fiscal and monetary policy responses, and changing behaviors compounds this difficulty. Our Multi-Asset Strategies and Solutions (MASS) team lays out how we assess inflation drivers and respond to help clients build resilient portfolios.

Long-term sustained rise, short-term uncertainty

Potential reasons for higher prices include higher production costs and deglobalization in the wake of COVID, new central bank policies that allow inflation “overshoots” to make up for past misses, and a risk of inflation expectations becoming unanchored amid greater debt loads.

We believe inflation is likely to be higher in the medium to long-term and portfolios should be positioned for this potential shift. However, we should avoid extrapolating too much from the extraordinarily high inflation readings in recent months, as they have been driven by factors that we feel are unlikely to be repeated over time.

Putting it in practice

As we seek to build portfolios that are more resilient to inflation, our portfolio construction approach is both diversified – deploying a wide universe of instruments and exposures – and dynamic – adaptable as circumstances change.

For example, we may express our views on inflation in multi-asset portfolios by reducing exposure to fixed income while diversifying into equities that can protect against inflation such as banks and energy stocks. We can also allocate to asset classes like commodities and inflation-linked bonds.

A long-term lens

The importance of employing a diversified approach goes beyond these tactical expressions of our views. Our research suggests that stocks and bonds are more highly correlated in higher inflation regimes. As shown in below, the sensitivity of the stock-bond correlation to inflation has approached global highs as coordinated policy response to COVID has made inflation a key macro driver of asset prices. The implication for portfolios is that bonds may serve as a less effective source of diversification in high inflation environments. We assert that this calls for a thoughtful, whole portfolio approach to meeting client’s investment objectives.

Stock-bond correlations have been sensitive to inflation