What works when inflation hits?

BY  |  

Over the past three decades, a sustained surge in inflation has been absent in developed markets. Today, inflation risk has increased. As a result, many investors are faced with the challenge of having little evidence regarding how to reposition their portfolios in the face of heighted risk.

Rather than predicting when (or if) inflation will increase to disruptive levels, we aim to answer a simpler question: What passive and dynamic investments have historically tended to do well (or poorly) in environments of high and rising inflation?

Why does inflation matter for asset prices?

Treasury bond prices are obviously impacted by unexpected inflation. Their current prices reflect an expected real interest rate, an expected rate of inflation and risk premium. If there is an unexpected surge in inflation, the expected inflation embedded in the yield increases and the bond price usually falls.

If the new level of expected inflation is long lasting, bonds with higher durations will be more sensitive than those with shorter duration bonds. A change in the uncertainty about inflation rates may also impact the risk premium.

Equities are more complicated.

First, higher and more volatile inflation creates more economic uncertainty, thus harming the ability of companies to plan, invest, grow, and engage in longer-term contracts. Moreover, while firms with market power can increase their output prices to nullify the impact of an inflation surprise, many companies can pass on the increased cost of raw materials only partially. Margins therefore shrink.

Second, unexpected inflation may be associated with future economic weakness. While an overheating may cause companies' revenues to increase in the short term, if the inflation is followed by economic weakness, it will decrease expected future cash flows.

Third, there is a tax implication for companies with high capital expenditures because depreciation is not indexed to inflation.

Fourth, unexpected inflation could serve to increase risk premiums (increase discount rates) reducing equity prices.

Finally, similar to bond markets, high-duration stocks (particularly growth stocks that promise dividends far in the future) are especially sensitive to increased discount rates.

The inflation mechanism for commodities, like bonds, is relatively straightforward. Indeed, commodities are often a source of inflation.