The Inflation Inflection

Equities have tended to outperform bonds during periods of higher inflation, but that appears to have more to do with the strong growth that often accompanies rising inflation, rather than inflation itself. The potential for a less favorable growth-inflation mix is therefore good reason to re-examine style and sector tilts in equity portfolios, but also to re-think the balance of passive versus active approaches.

Fixed income portfolios are arguably most at risk from an inflationary environment. Inflation and higher rates tend to lower the present real value of a fixed income stream. The longer-dated those income streams are, the more sensitive their present value is to changes in rates—they exhibit longer duration. Should a long-term real yield of 1% or even zero be required to make inflation settle between, for example, 2.5% and 3.0%, nominal yields will be substantially higher than they are today.

Historically low bond yields, tight credit spreads and high equity market valuations raise the likelihood that stocks and bonds will become more correlated and more volatile. In our view, the potential for structurally higher inflation and a less favorable growth-inflation mix increases that likelihood still further. The traditional 60/40 portfolio appears vulnerable. We think alternative diversifiers will need to play a more prominent role, with a focus on those with particular sensitivity to inflation.