The consumer price index. The producer price index. The personal consumption expenditure price index.
Pick any cost barometer these days, and the story is the same: Prices are up – and dramatically. By each measure, US inflation is operating at the highest level for decades – an uncomfortable fact recently confirmed by the release of the U.S. Consumer Price Index (CPI)) for February, which showed last month’s consumer prices rose at the fastest pace since January 1982. And, to add to investor concerns, the February survey was conducted before Russia invades Ukraine on February 24, sending energy prices skyrocketing on supply concerns.
Despite all the bad news, we think inflation could peak by summer, with price pressures starting to ease as supply catches up to demand, economic growth slows and the Reserve federal government (Fed) continues to tighten its monetary policy. By the end of this year, we expect core inflation – as measured by the Fed’s preferred indicator, the Personal Consumption Expenditure (PCE) price index – to fall to about 2.75%-3.0%.
A reading of 2.75% to 3.0% would bring inflation closer to the Fed’s 2.0% target and represent the start of a return to what are generally considered normal levels of pressures. on prices. But what if we were wrong? What if today’s high inflation environment persists for several years? What could be the implications for investors? Which asset classes could perform better than others?
While such a scenario falls far short of our baseline scenario of inflation moderating later this year, it cannot be ruled out entirely and seems appropriate to approach from a In case point of view.
So, without further ado, let’s dive into the nitty-gritty, starting with how different asset classes have fared during previous periods of high inflation.
Which assets generally perform better in times of high inflation? It depends on the growth.
Before going any further, let’s make one thing clear: inflation is do not good for financial assets. Full stop. While qualified investors may realize reasonable returns in such environments, in almost all cases, strong real returns are irrelevant.
That said, some asset classes tend to perform better than others on a purely relative basis. Which? It is important to note that the answer depends on the type of growth environment that exists at the time – in other words, whether economic growth is high, medium or low.
To understand why, let’s take a look at the chart below, which shows the average monthly returns in six different regimes.1 – three marked by low inflation and three marked by high inflation. The three high inflation regimes are broken down by the type of economic growth that was present at the time – high, medium, or low.
Low growth/high inflation: an unfavorable environment for most assets
The first thing that jumps out at you is the dismal performance of most asset classes during periods of low growth and high inflation – otherwise known as stagflation. Since the mid-1980s, under these regimes, equities have performed poorly across the board, with gold, global commodities and US REITs (real estate investment trusts) also lagging behind. Only certain types of fixed income instruments, such as US Treasuries, investment grade corporate credit and mortgage-backed securities, generated meaningful returns.2
To put it bluntly, in such an environment, there are very few places for investors to hide. The combination of low growth and high inflation is like a perfect storm – except there is no escape.
Note that results become more mixed in medium growth/high inflation regimes, with US equities doing slightly better while emerging market equities lead the pack with an average monthly return of 1.7%. Gold, commodities, TIPS and hard EMDs are also doing well. Meanwhile, the parent winners low growth and high inflation regime saw a modest decline in returns.
High Growth/High Inflation: Stocks Do Better Than Most
It is perhaps unsurprising that the chart shows that during high growth/high inflation regimes, asset class performance was essentially reversed from what happened during low regimes. low growth/high inflation. U.S. equities, developed international equities, emerging market equities, global commodities and REITs all posted average returns of 1.0% or more, while Treasuries, mortgage-backed securities and investment grade credit saw their gains reduced. In contrast, fixed income instruments that performed poorly in a low growth environment, such as emerging market debt and US high yield credit, saw significant improvements.
If the results of this environment look familiar to you, it’s probably because they’re not too far off from the typical performance we expect from equities and long-term fixed income securities. Indeed, over the duration of a market cycle, equities tend to generate higher returns than fixed income securities.
The importance of considering the growing environment
Above all, this chart demonstrates that in times of high inflation, a strong correlation exists between the performance of asset classes and the state of economic growth. In other words, for investors looking for yield, growth conditions are just as important as inflation conditions. It’s just not enough to only look at the overall performance of an asset class during previous high inflation regimes – because that performance will vary greatly depending on the type of growth environment that was present.
Considerations for investors today
For investors contemplating shifts in their portfolios today, this means understanding that successful strategy shifting requires correctly forecasting the future state of of them variables: Inflation and economic growth. Nailing even just one of these ever-changing variables off a tee would be a rather difficult task – but guessing correctly on both?
Consider, for example, the example of an investor who is adamant that a low growth/high inflation regime is in store for the next 12 months (as mentioned above, we believe the likelihood of this result is very low). Taking a leap of faith and acting on that belief would mean moving a lot of money from stocks to bonds – and the results could be detrimental if growth is higher than expected or if inflation becomes unbalanced like in the late 1970s. , hurting nominal bond yields. more than stocks. Investors should instead assess the risk of downside growth/inflation patterns that are key to their asset allocation policy and, if necessary, adjust for better risk management, to withstand such periods. without significantly deviating from their long-term investment objectives.
The bottom line
A good forecast of economic growth in addition to inflation is necessary to support changes in asset allocation policy driven by inflationary concerns. However, investors should carefully assess their confidence in the outlook for growth and inflation. When inflation runs high, so do investors’ emotions – after all, the temptation to sSomething in the face of massive price increases is only natural. But for investors, even controlling inflation is only half the battle. The other part – projecting medium-term growth rates – is equally difficult. And with so much money at stake, are the downside risks associated with large changes in asset allocation really worth it?
We do not think so. Sometimes it’s better to stay calm, recheck the hatches and move on.
These views are subject to change at any time based on market or other conditions and are current as of the date shown at the top of the page. The information, analyzes and opinions expressed herein are provided for general information only and are not intended to provide specific advice or recommendations to any person or entity.
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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.