The news that US inflation had reached a 13-year high put pressure on equity and bond markets last week. The S&P 500 and Nasdaq fell 2.2% and 2.7% respectively on May 12, and the bond rout witnessed earlier this year appeared to resume.
US consumer price data for April showed inflation in the 12 months leading up to April 2021 rose 4.2%, the fastest pace since 2008 and above the 3.6% forecasted by economists. The country's core inflation, which measures the price of goods and services excluding food and energy, also rose 3%, the largest annual increase since 1996.
While some analysts argue this is a transitory side-effect of pandemic recovery (and so unlikely to trigger a Federal Reserve response), rather than the start of an upward price spiral, investors have been nonetheless forced to assess the resilience of their portfolios.
Assets traditionally known to perform well against inflation include gold and treasury inflation-protected securities (Tips), as well as real assets whose prices will rise with inflation. Technology stocks – whose valuations are squeezed by inflation – and long-term fixed income investments tend to fare less well.
One columnist even argued that collectible coins might be the safest inflation hedge of all.
This week we asked investment professionals to give us their two cents' worth on which asset classes they expect to perform best if the inflationary spike persists.
The following responses have been edited for brevity and clarity.
Harsh Parikh, head of real assets research programme
PGIM Institutional Advisory & Solutions
Expected inflation is 3.4% and expected GDP is 6.3% for 2021 and 4.3% for 2022. Quite a change from a year ago.
Investors looking to position their portfolios for this changing economic environment are considering real assets. What may surprise investors is that real assets differ widely in terms of their inflation and growth sensitivities.
Consequently, we rely on our real assets sensitivity framework to construct a real assets portfolio. Investors with a “stagflation-outlook” - that is high inflation and low growth - will have a real assets portfolio that looks very different to an investor with an “overheating-outlook”, who see high growth and high inflation.
Real assets that are well-suited to an overheated market environment are natural resource equities, Reits, infrastructure equities and commodities. Real assets like gold and Tips, meanwhile, are better suited to a stagflation environment.
Chang Hwan Sung, director of solution research
Even though we believe inflation in the US will be transitory, we believe it could cause more volatility in the markets in the short term.
As leading economic indicators are still improving and risk appetite is strong, within fixed income we prefer higher risk assets. And bank loans stand out within fixed income as they provide higher income with little duration risk, hence can deliver stable returns even when rates are volatile.
On the currency side, we are constructive on currencies that can benefit from this cycle with a favourable backdrop for capital flows, but with attractive valuations, such as Indonesian rupiah, Russian ruble and Brazilian real, as well as Euro, Canadian dollar, Singapore dollar and Norwegian krone.
Finally, while inflation is rising across all sectors of the economy, above average contributions have come from import prices (energy prices and dollar depreciation) and the manufacturing goods sector, hence we prefer stocks that can benefit in this environment.
Wenting Shen, solutions strategist in the multi-asset division
T. Rowe Price
Based on our research, many asset classes, including nominal assets, tend to directionally compensate for expected inflation, however it is the unexpected inflation that is harder to hedge. Assets with positive inflation sensitivity such as real assets equities (which include companies related to assets that have physical properties, such as natural resources and real estate) and Tips tend to have relatively strong returns when faced with unexpected inflation.
To mitigate inflation risks, both expected and unexpected, we believe investors should consider investments that could potentially benefit from higher inflation. Traditional asset classes such as value, small cap, and emerging markets equities tend to perform well when inflation and economic activities both rise, while real assets equities provide a buffer against unexpected inflation. Within fixed income, short-term Tips and floating rate loans may be attractive options.
In our portfolios, we have maintained an underweight position in real assets equities since 2011 as a result of subdued inflation. Starting from this year, however, we have gradually closed some of the underweight positions as we expect the release of pent-up demand will continue to drive up inflation. Within equities, we continue to favour cyclical sectors with attractive relative valuations. They are expected to benefit disproportionately from the post-pandemic economic recovery.
Michael Grady, head of investment strategy and chief economist
The recent increase in US consumer price inflation raises the spectre of whether we are leaving a decade-long period of historically low and below target inflation. While the year-on-year increase in headline inflation was certainly eye-catching, there are reasons to believe that some of the increase is likely to be transitory, reflecting very weak energy and other goods prices last year and some specific supply bottlenecks that have emerged in manufactured goods this year.
Underlying inflation pressures are more subdued, although likely rising over the coming year as spare capacity is eroded. We expect that backdrop of a transitory increase in inflation, followed by a more sustained pickup in underlying inflation pressures, is likely to put longer-term government bond yields under further pressure this year, as both breakeven inflation and real rates rise.
We expect that will also put certain parts of the equity market under pressure – in particular, expensive, high growth companies and sectors. Instead, we prefer to tilt our exposure to a combination of value and cyclical sectors, such as financials, energy and industrials. Similarly, within currencies, we prefer to be long on those that traditionally benefit from rising commodity prices, such as the Canadian dollar and Norwegian krone.
Andrew Zurawski, associate director, investments Asia
Willis Towers Watson
Our central forecast is for the increase in inflation over 2021 to be largely transitory, and as such inflation is expected to be lower in 2022. Having said that, we do see a much more significant risk from higher inflation relative to the pre-Covid period, and investors can consider assets which provide an implicit or explicit inflation hedge.
Historical episodes of higher inflation tell us that real assets, such as prime real estate and infrastructure, tend to perform well as their cash flows are linked to inflation. Commodities have also usually performed well during inflationary periods, although implementation of commodity exposure can be difficult. In addition, inflation-linked bonds offer inflation protection but they can generate losses if real yields increase from their current very low rates.
Finally, equities and nominal bonds usually perform poorly when inflation is high, although equity returns may be supported in the short-medium term by strong earnings growth and very low discount rates.