Inflation in 2022: more scenarios demand more clarity 

In early 2022, I moved from London to Missouri for many reasons, including wanting to pay less for gas. In London, $9 per gallon for gas was standard, while in Missouri the rate was closer to $2.50. In my eagerness, I bought myself a brand-new truck and began planning road trips for the year ahead.

Six months later, gas is now $5 per gallon, even in Missouri, and I’ve had to scale down my road trip ambitions as I'm now paying $100, rather than $50, to fill up my tank. When it comes to energy but also in other areas, I can now really feel how inflation is reducing my buying power.

This personal anecdote helps illustrate how for the first time in 40 years, inflation is impacting us all in a meaningful way, in our personal lives, businesses and of course portfolios. At Mercer, we have highlighted rising inflation risk since 2018, and in summer of 2020 we recommended that investors proactively build inflation protection into their portfolios. We have been continually refining that advice ever since.

Several short-term factors have driven recent inflation.

For instance, fiscal stimulus funded by debt and money printing throughout the pandemic kept consumer demand high at a time when supply chains were being constrained by lockdowns. Now, with the worst of the pandemic now seemingly behind us even if most of the world has done away with restrictions, supply chains remain damaged – a factor that is further exacerbated by the conflict in Ukraine and its consequences for commodity markets.

Meanwhile, labour costs are high partly because of a wave of early retirements as well as the so-called great resignation. Coming to Boston ahead of the GIF, I had to wait an hour for a cab – a real-world indication of the shortfall in staffing numbers.

The 8.6% inflation peak seen in June is the highest since the 1980s. While that figure has rightly grabbed headlines, inflation risk is not just about current inflation. Long-term drivers are shifting inflation risk upwards too and this is what informs our view that long term inflation risk has increased. A precedent of ‘helicopter’ money to fund government programmes has been set and may be used again in the future. The Ukraine conflict has set in motion a time-consuming realignment of commodity supply chains which makes us susceptible to future commodity shocks. High levels of public debt incentivises debt monetisation. Globalisation, one of the most important disinflationary of the last three decades may be slowing.

For investors, understanding how these factors may play out is central to implementing a successful inflation-protection strategy, which is why I had the privilege of sharing some of my work with Mercer’s US Global Investment Forum (GIF) attendees in Boston.

One thing is almost certain in investing – the future will be different from the past, and that applies to portfolio construction. The questions we are seeing from clients are not only about how to bring inflation-protecting access into portfolios but deeper questions about how portfolio construction will have to change in a higher inflation regime – think of equity-bond correlations turning positive.

Typically, bonds have protected portfolios during short term market turbulences, but not this year. In a more stable, lower-inflation environment, inflation used to come with growth. And even if yields went up and bonds would perform poorly, equities would still do well because it was a good environment for business. In this environment, equities do well when bonds do poorly and vice versa. Bonds can then add potential downside protection to portfolios.

In a more volatile inflation environment, however, which is what we are seeing today, this lesson in portfolio construction does not necessarily hold. For inflation may now coincide with lower growth at times with central banks having to hike in recessions. In this environment, bonds and equities both tend to do poorly. Bonds do not offer potential downside protection anymore.

Therefore, we need a new approach, Mercer’s scenario analysis can help here. It is a tool that we believe is more crucial than ever because inflation comes in different shapes and forms and the range of outcomes has now widened. And with history not set to repeat itself, the tool is designed to provide insight and clarity on how Mercer can guide clients through this difficult time by understanding the impact of different inflation scenarios on asset classes.

So where should investors put their money to be prepared for future inflationary shocks? We believe that the answer is to diversify. We know that no asset classes work equally well in all inflation scenarios. Real Estate Investment Trusts (‘REITs’) and commodities, for example, work well in different inflationary environments. Therefore, for a robust inflation-protecting framework, various asset classes are required to cover a broad range of scenarios because there is no silver bullet single asset class that protects against all inflation scenarios at once.

The mantra of not putting all eggs in one basket also holds in more inflationary times.