Research report

Higher inflation has come for the 60/40

Investors have not truly had to contend with higher inflation for decades. We break down the impact inflation has on fixed income markets, equities, and the dynamics of the 60/40 portfolio.

Download the report
November 23, 2021 | 17 minute read

Higher inflation is here, raising questions for investors about the economy and financial markets. We expect inflation to persist well above pre-pandemic levels through 2022, but the arc of this inflationary cycle is highly uncertain. We outline the impact on fixed income and equities, and discuss how higher inflation changes the dynamics of the foundational 60/40 portfolio.

Key takeaways

  • The risk to fixed income is significant as real interest rates turn deeply negative.
  • Historically, high and rising inflation challenges equity returns in the coming year.
  • Inflation above 2% has caused diversification of the 60/40 portfolio to break down.
  • The outlook for inflation is uncertain, but even moderately higher inflation can cause significant challenges.

Higher inflation has arrived, and looms as a top challenge for investors in 2022. For two decades, the threat of inflationary pressures has been largely dormant. Low business cycle volatility, including relatively long expansions of the 1990s and the 2010s caused inflation expectations to anchor closely or slightly below 2%. Bouts of surging oil prices briefly caused headline inflation to jump in 2008, but core inflation which excludes food and energy prices remained stable at a low level. This placid backdrop has come abruptly to an end. In October, headline inflation hit 6.2% y/y, the highest since 1990. Energy prices are up 30% y/y and food prices have risen 5.3% y/y. Inflation is bubbling up from varied sectors of the economy outside of the volatile food and energy components. Core inflation is up 4.6% as durable goods prices have skyrocketed 13.2% y/y, but services prices are accelerating, too, led by transportation services.

Consumer price inflation

Source: Bureau of Labor Statistics, as of November 16, 2021. 

In the U.K., regulators directed firms to stop issuing GBP LIBOR-referenced debt beginning in April, and SONIA issuance has grown significantly since then. While these cash and derivative markets are much smaller compared to those in the U.S., the uptick in liquidity is significant. In addition to the importance for their domestic markets, it has also been a positive development for U.S. market participants who have multi-currency debt facilities and/or cross-currency swaps. Broadly speaking, the adoption of global LIBOR replacements.

For investors, it is important to recognize that even moderate inflation can impact both fixed income and equity portions of a portfolio. Short-term interest rates are rising, offering an opportunity to shorten duration to navigate the upcoming Fed rate hike cycle. But with interest rates near historic lows, inflation quickly erodes income.

On the equity side, inflationary periods have historically not been an environment of easy returns. The combination of high inflation and a rising inflation environment has been the most challenging. As investors address the implications of inflation to both sides of their portfolio, an added complication comes from the fact that inflation changes the nature of how these two broad asset classes interact with each other.

Inflation is unlikely to evaporate, and thus we can expect inflation to continue to dominate the discussion in markets, among policymakers, and at home in the economy. If higher inflation feels different, it is because it is something investors have not truly had to contend with in decades. It may be time to recalibrate portfolios with the implications of higher inflation in mind.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Brian Cho, CFA

Managing Director, Head of Quantitative Research, Chiron Funds

Lara Rhame

Chief U.S. Economist + Managing Director

Search our site