Investors beware

Pandemic‑related spending has unearthed a forgotten risk: inflation. This column will strive to address the danger that inflation poses to traditional, ‘balanced’ portfolios and the safety of clients’ investments.

What has changed?

The disinflationary forces of the past 40 years have lulled investors into a false sense of security. It has taught them not to fear inflation, indeed, that inflation is dead. However, 2020 saw a marked departure from recent macroeconomic policy as governments waved goodbye to austerity and ushered in fiscal spending at a pace and scale not seen since the World Wars. Central bankers are confident they can let the economy run ‘hot’ and that they can control inflation if it comes. This author disagrees and thinks they are walking a precarious inflationary tightrope, unable to increase interest rates in the face of ballooning debt levels.

Why it matters

Traditional ‘balanced’ portfolios of bonds and equities assume a negative correlation between these assets, allowing them to act as effective offsets or ‘diversifiers’ to reduce risk within a portfolio. However, if inflation rises, then both of these asset classes are likely to fall in tandem, rendering a traditional portfolio much riskier than anticipated. One only needs to look back to the 1970s when inflation destroyed a typical 60:40 portfolio (60 per cent equities, 40 per cent bonds) in real terms. However, we do not need 1970s levels of inflation to destroy traditional investment portfolios. Let us take each asset in turn.

Bonds

Rising inflation makes a bond’s fixed cash flows less attractive. Investors become less willing to accept a future sum with a lower value and this feeds through to lower bond prices. Conventional bonds (not inflation‑linked) will no longer fulfil the role of low‑risk, diversifying assets in an inflationary landscape.

Equities

Contrary to popular opinion, few equities truly protect against inflation, at least not meaningful inflation. Many equities de‑rate (fall in price) as investors are willing to pay less for future earnings. Equities therefore become positively correlated with bonds (falling in tandem) at a time when 60:40 portfolios are depending upon equities to be the offset.

What is the solution?

If inflation rises, the journey ahead is unlikely to be smooth for economies, currencies or asset prices. Investment managers will need to build more diverse ‘all‑weather’ portfolios that are resilient to changing market conditions and can protect against these scenarios, without trying to precisely time markets. The author suggests positioning for the inflationary road ahead through a mixture of inflation‑linked bonds, gold and unconventional assets to protect against future dangers that could spell the demise of traditional portfolios.