Quick Clips: Managing Inflation Risk
Uncertainty over inflation has been unusually high this year, as rapid economic growth has been accompanied by large increases in prices for many goods and services. While economists had long expected that reopening following COVID-19 shutdowns would feature some degree of upward pressure on prices, the magnitude of acceleration in U.S. inflation was unexpected by most forecasters.
Inflation increased sharply in 2021, with the U.S. Consumer Price Index (“CPI”) reaching 5.4% in the U.S. for the year ending in June, and maintaining that rate three months later. Perhaps even more notably, U.S. core CPI, which strips out more volatile energy inputs, exceeded 4% for the first time since the early 1990s. While many have suggested that these pressures may be short-lived, uncertainty around the future path of inflation should prompt investors to question how different inflationary outcomes can impact their portfolio. Inflation and asset return data show that both stocks and bonds have historically underperformed during environments of rising or surprisingly high inflation.
Inflation is a serious risk for investors with portfolios primarily consisting of stocks and bonds (0:38)
Other asset classes, such as real estate, commodities, and Treasury Inflation-Protected Securities (“TIPS”) 1 1 Close Treasury Inflation-Protected Securities (“TIPS”) are Treasury bonds whose principal and coupons are indexed to the Consumer Price Index. , are often considered to offer more resilience to inflation. Historical data suggest that allocations to some, but not all, of these asset classes can provide valuable diversification during inflationary episodes, thereby reducing portfolio sensitivity to inflation.
Evaluating the ability of real assets to protect against rising inflation (0:43)
Diving deeper into the relationship between asset classes and inflation, we see a tendency for equities to also underperform during periods of falling inflation – potentially due to these episodes having coincided with adverse growth shocks. This pattern highlights the potential benefit of strategies that offer upside inflation protection without suffering in disinflationary recession environments.
Two strategies have tended to thrive during both upside and downside inflation surprises (0:38)
If inflation does continue to rise, investors may see a more favorable environment for inflation-sensitive assets, including TIPS Breakevens and commodities, and also for dynamic strategies like managed futures and global macro. Such an environment may also present challenges for stocks and bonds, which have historically delivered subpar returns in periods of rising inflation.
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