Navigating higher and persistent inflation

It is likely that we are moving into a regime of higher and more persistent inflation, meaning that a simple balance portfolio is likely to be less diversified. Any regime change creates risks, which usually translate into a short period of underperformance until investors adapt.

Following 10 years of low inflation, investors are having to shift their mind set. Risk premia such as earnings yield, credit spreads or nominal rates will have to increase in the face of low expected real returns.

We are not used to this. In the last decade, the cost of refinancing had to fall below low and decreasing nominal economic growth rates to avoid depression. In the post-war 1950s, debt levels had risen and nominal GDP fluctuated widely between 0 and 10% with Fed Fund rates varying between 0% and 3.5%. This represented a rare occasion when the global economy managed to absorb higher risk premia and a falling real cost of borrowing and led to an extended period of sideways, volatile asset prices.

Correlations are changing and challenging our assumptions and models, most of which rely on approximately 20 years of data. We are now in a higher volatility regime with large daily price fluctuations becoming the norm and dispersion within asset classes is likely to remain elevated. The pace of economies reopening will impact supply chains and local demand dynamics. Meanwhile, commodity price inelasticity and labour market imbalances are likely to contribute further to inflationary pressures. Risk premia will deliver lower expected returns and carry-related positions will continue to reprice. 

Investors will have to be more clinical in understanding regional and sector specific risks and how securities and assets can withstand higher inflation and variable nominal growth. Key for investors navigating this environment will be to focus on forward looking scenario analysis for portfolio construction, alongside a deep analysis of regime change to understand potential sources of return. The ability to adapt will be critical for performance in the coming years.