Understanding the impact of inflation on investments 

Following a prolonged period of low inflation and interest rates across most of the world, we are now traversing an economic and market environment that many of us — whether as consumers, investors, business leaders or employees — have never before experienced. 

Inflationary forces escalated over the last couple of years, spurred by a combination of supply chain disruptions and the unprecedented policy response to curb an economic meltdown following the outbreak of the pandemic. The more recent Russia-Ukraine crisis amplified existing inflationary trends. 

With inflation reaching multi-decade highs across major economies during the first half of this year, a sustained period of central bank rate hikes will probably be required to bring inflation under control. But central banks must walk a precarious tightrope to ensure that rate hikes do not trigger a painful economic slowdown.

Inflation is hard to predict. While we expect inflation to decline over the next year, it could remain above central bank targets for a number of years. In a multi-polar world that is more vulnerable to geopolitical or climate-related events, the risk of outsized moves in commodity markets or other crucial inputs — such as semiconductors — means that more frequent inflationary shocks or even bouts of stagflation will remain more than just implausible tail risks.

Traditional portfolios, dominated by equities and bonds, have performed exceptionally well through the disinflationary environment of the prior decade, but they are ill equipped for an environment of persistently higher and more volatile inflation.  

Given the uncertainty about the path and outcomes of prospective inflation and rate hikes, it is important to ensure that portfolio diversification and governance processes are robust. Acknowledging that we lack a crystal ball to predict the future with certitude, portfolios with diversified return drivers are more resilient across the wide range of plausible future scenarios. Equally, strong and nimble governance provides the foundation for investors to capitalize on opportunities in this highly dynamic market environment.

We believe that investors should review their inflation protection, noting that inflation is not a homogenous phenomenon. It can manifest in different ways, and the risk posed by different scenarios evolves over time. There is no single investment strategy that works all the time and across all inflationary scenarios, so diversified exposure across a range of inflation-sensitive assets — which could include inflation-linked bonds, infrastructure, gold and other commodities — is a more pragmatic solution.

Investors who do not already own inflation-sensitive assets need to be mindful that some prices have increased considerably over the last year, but market volatility may present opportunities to increase hedges against inflation risk for the long term.

Ultimately, the mix of assets appropriate for an investor will depend on a range of factors, including the investor’s existing asset mix and time horizon, under which scenarios the portfolio is most vulnerable, and other investor-specific constraints — such as climate transition and ESG considerations. Investors should discuss their individual circumstances with their consultants. If you have any questions, get in touch with us today!