Fidelity: Six strategies to deal with higher for longer inflation

Key points

• Inflation appears to be slowing, but betting on a swift return to the low and stable inflation of the last two decades is not a historical inevitability.
• Higher duration asset classes do not fare well in a world of inflation fears. From the 1970s to the 1990s, a 50/50 equity/cash portfolio had a much better risk-reward than 50/50 equity/bonds.
• From an asset allocation perspective, there are several things that investors could consider if we enter a period of higher and more volatile inflation.

Inflation remains stubbornly high, with core measures trending around 5% or higher in many major economies. While several factors point to a further slowing in inflation - including, for example, contracting money supply and weak economic growth - inflation has historically proved very hard to tame. There is a still material risk that we enter a period of high, or at least more volatile, inflation like we saw from the early 1970s until the late 1990s. Betting on a swift return to the low and stable inflation of the last two decades is not a historical inevitability.

This has huge implications for multi asset investors. Most importantly, in a world of inflation fears, we believe government bonds will be positively correlated with risky assets. This makes 'duration' a poor hedge for portfolios. Indeed, from the 1970s through the 1990s, a 50/50 equity/cash portfolio had a meaningfully better risk-reward than 50/50 equity/bonds.

From an asset allocation perspective, we believe there are six key ways for investors to potentially navigate a period of higher for longer inflation.

1. Consider equities and low-duration credit exposure (for example, short-dated credit, floating rate bonds/loans, or traditional credit with a duration hedge). The important thing is to take enough risk to beat inflation over time, while acknowledging that long duration assets may be challenged.
    
2. Consider tilting towards market areas that will be strongly correlated with inflation pressures. Listed renewables and infrastructure, for example, are correlated with the inflationary pressures of decarbonisation and fiscal spending. Healthcare has pricing power and is associated with the mega-trend of demographics, which may also prove inflationary. Some would recommend REITs and energy stocks as inflation hedges. However, this is at odds with today's stretched housing prices relative to income and mortgage rates (unlike the 1970s) and the need to move towards decarbonising the global economy.
    
3. Consider an allocation to commodities and miners that will benefit from demand mega-trends. This is very risky, however. Ideally, the commodity should have a negative correlation with markets - and be good value relative to marginal cost - otherwise it may be a significant source of portfolio volatility. Copper may be a sweet spot, benefitting from the ongoing multi-year move to electric vehicles.
4. Consider alternative forms of portfolio defence, such as hedge funds or long volatility strategies.
    
5. Consider inflation-protected bonds (e.g., TIPS), or even inflation swaps directly. While these are not necessarily a great structural holding - real yields sold-off significantly as central banks moved to fight inflation - they now offer a positive 'real' yield and protection if inflation remains stubbornly above central bank targets for the next decade.
    
6. Be more tactical - portfolios will be more volatile in a higher and more volatile inflation environment. There are always countries that offer a relatively better inflation outlook. Currently, we see attractive debt and equity opportunities in selected emerging markets, such as India, Indonesia, Brazil, and South Africa.

In summary, the outlook for inflation remains uncertain. Given this backdrop, investors should be proactively thinking about ways to position for a potential longer-term regime change in market, even if this does not ultimately come to fruition. From an asset allocation perspective, our focus remains on being flexible, closely monitoring the evolving macro picture across developed and emerging markets and embracing the breadth of opportunities multi asset portfolios can offer our clients.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in emerging markets can also be more volatile than other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.