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.
- 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.