Inflation is back after 40 years – what this means for client portfolios

The return of inflation

The last 40 years have largely been a period of disinflation – falling inflation and interest rates. This is a very favourable investment environment for risk assets (charts below).

Over the last year, however, most countries have experienced higher inflation (chart below). Many of the world’s major central banks including the US Federal Reserve have shifted from assuring investors that this is just a temporary blip to reversing policy and governments are increasingly winding back their fiscal deficits.

Inflation has largely been ignored by equity and bond markets, as evidenced by the current level of valuations, although the market no longer believes the transitory story as wages growth lifts and supply pressures increase.

Why is the market so concerned about inflation?

The reason that markets are particularly concerned about inflation now is that the spike in inflation is occurring at a time where we may be at the end of a long secular economic cycle of disinflation, which was prolonged by the government and central bank stimulus measure since the GFC in 2008.

The diagram below illustrates this point.

Generally, what concerns the market now however is not the likelihood of sustained high inflation (although this is a possibility), but rather unexpected spikes in inflation or stagflation due to central banks not taking action or to the contrary the recessionary consequences of overreacting and lifting interest rates too quickly and governments prematurely increasing taxes to repay debt. It is these “transition” periods that cause dislocations in the market. The end of the cycle is an added complication impacting longer-term portfolio construction.

Overall, even the most optimistic outcome is that inflation will remain above pre-pandemic levels.

The problem for conventional portfolios in periods of high inflation

Most portfolios have been constructed during and for disinflationary environments. Those asset classes such as equities, real assets, and more aggressive credit-oriented fixed income strategies that are linked to GDP growth performed well.

Further, portfolio efficiency was supported by the typically negative correlation between equities and bonds (duration) that dampened portfolio volatility when periods of market stress occurred.

The concern is that the market is far more fearful when inflation is already high and especially at current stretched valuations, equity/bond correlations may fail to work just when investors need them to (as was seen in October).

There are many portfolio construction challenges when deciding how to respond to different inflation regimes. Two major ones are:

• The difficulty in predicting the timing and degree of the change, much of which depends on the actions of the US Federal Reserve
• Asset classes perform quite differently in different inflationary environments.

The following chart illustrates the latter point

Best-performing* asset classes under each US economic environment since 1950

So how can advisers respond to inflation?

It is not feasible to build an “optimal” portfolio that will constantly shift to outperform at all times as the level of inflation changes. In the face of such uncertainty, what should advisers do in such an environment? In our view the answer comes down to two fundamental points:

• Having a robust investment and portfolio construction philosophy, consistently applied, proven through a range of economic cycles, and supported by a decision-making framework that can quickly adjust portfolios
• Understanding the needs and goals of the client

Investment philosophy

Our recommendation to advisers is for portfolios to have:

• A strategy that is well diversified by asset class; risk premia and investment manager
• Predominantly active investment managers to guard against concentration risk and to avoid poor exposures in various asset classes: especially for emerging markets (where the driver of inflation is critical), small caps, and REITS (which depend upon the nature of the underlying rentals)
• Active management of the asset allocation, with a valuation aware framework
• A blend of managers with a range of exposures to growth, value, cap bias, and region (including emerging markets) for equities. Growth stocks for example are overvalued and will not respond well to inflation at current valuations especially. Value stocks however offer significant opportunity at present
• In the case of fixed income portfolios, the inclusion of short duration, absolute return, active management of credit quality, and the ability to rotate in/out of asset classes as conditions change
• The flexibility to introduce new asset classes, such as growth and defensive alternative assets and real assets (such as commodities, global macro), low volatility equities, long/short. Care needs to be exercised with assets such as inflation-linked bonds, gold, and commodities that have mixed records over the long-term.

The needs and goals of the client

Just as there is no silver-bullet portfolio that protects against all inflation scenarios, advisers know that no two clients are alike in preferences and financial situation.

Firstly, advisers need to look at the starting portfolio and determine under which economic scenario the asset mix (including wealth outside of super) is vulnerable.

Clients that are near or in retirement will be sensitive to inflation in two ways – firstly as their spending power will be reduced and secondly their increased vulnerability to a sequencing risk event. They will also need a fixed income portfolio that provides a good level of cash flow while protecting against capital loss.

Accumulation clients under say 55 on the other hand will be less sensitive to inflation risk and will continue to see equities as the driver of long-term wealth.

Also relevant is the type of inflation protection needed, for example, education and healthcare increase in cost at a far greater rate than CPI.

The client tolerance for complexity and the frequency of changes in the portfolio will be an important factor.

Lastly, managing expectations is important, clients need to be made aware that returns are likely to become more volatile and generally lower.

Conclusion

The risk of structurally higher inflation and a more volatile and lower returning investment and economic environment may be upon us whether we like it or not.

This will create an environment where advisers can demonstrate the value of advice and the benefits of robust diversified portfolios backed by a strong governance framework.

Brian Long, senior investment specialist, managed accounts, Lifespan Financial Planning

Neil Griffiths

Neil is the Deputy Editor of the wealth titles, including ifa and InvestorDaily.

Neil is also the host of the ifa show podcast.