What does the current inflationary environment mean for multi-sector fixed income portfolios?

We are constructing multi-sector fixed income portfolios that accord with our expectations of persistent and elevated inflation rates. While we do expect headline and core inflation rates to peak this spring, any fall will likely leave inflation rates in the U.S. and Europe at or above target levels over the next 12 months. In our view, inflation will remain a key factor for portfolio construction for many quarters to come.

What does this mean in practice for multi-sector fixed income portfolios? We are focused on three key expressions for a persistent inflationary environment.

First, we are maintaining relatively low duration, or portfolio interest rate sensitivity, and are positioned for the yield curve to remain flat or continue to flatten. In essence, we expect the inflation environment to drive the Federal Reserve (Fed) to continue hiking. Upward pressure for interest rates will likely remain, particularly for the maturities most sensitive to future Fed tightening.

Second, we are focusing our asset allocation on higher weightings to sectors that should, over time, have less sensitivity to rising interest rates. Areas such as bank loans, collateralized loan obligations (CLOs), and securitized credit that have floating rates are natural areas, but short duration high yield or short duration emerging markets can also play important roles in providing income and total return while minimizing volatility due to interest rate sensitivity.

Finally, we expect company and sector exposures to become more differentiated. For example, sectors that should see stronger revenue growth, such as travel and leisure, likely have better tailwinds for performance than sectors that could see pressure from rising interest rates, such as housing. Likewise, rising labor costs are not impacting all companies or sectors equally: we observe more pressure in consumer products areas, for example. In essence, we are focusing security-level investments in sectors and companies that we believe to be relatively insulated against, or even potentially beneficiaries of, this inflationary environment.