Inflation: the only question that matters

We unpick the cosy consensus on inflation.

Key points

• For a decade now, the behaviour of all investors has been predicated on the belief that there is no chance of a sustained acceleration of future inflation.
• The fund management industry has calibrated a structural asset allocation that thrives when disinflationary forces dominate.
• The greatest investment risk is a failure of imagination in understanding how the game might fundamentally change.

Ultimately, determining whether we are living in an inflationary or disinflationary world is the most fundamental question that long-term investors must get right, and will have repercussions in terms of the type of investment strategies that thrive. While the last 40 years have been disinflationary, arguably the last 10 years have also been deflationary. That is not to say that the prices of many things have not gone up, as of course they have, and in many cases significantly. But expectations of inflation have been declining for more than 30 years and have been rock-bottom since the financial crisis.

For a decade now, the behaviour of all investors, from the smallest individual investor to the chair of the Federal Reserve, has been predicated on the belief that there is no chance of a sustained acceleration of future inflation. The most pervasive and powerful piece of received wisdom in investing has been that we are destined for a future of low growth thanks to too much debt and demographic trends.

Investing in a disinflationary world has been a relatively straightforward affair. Both equities and bonds – the mainstay of investment portfolios – have been in structural bull markets for two generations. Furthermore, equity and bond-market returns have been negatively correlated, particularly around turning points in the economic cycle.

This made portfolio construction easy: the lion’s share of a portfolio was dedicated to equities, and in order to hedge against equity bear markets, a substantial portion of the portfolio was allocated to government bonds. In the event of an equity bear market, bonds would appreciate, offsetting losses on equity holdings.

Meanwhile, bonds would deliver capital losses to investors once the equity bear market came to end and markets and economies reflated, but, after the initial recovery, disinflationary forces would limit the rise in bond yields. At this point in the market cycle, government bonds would serve to hedge against deflation and an equity bear market while paying investors an income along the way. Investors really had the luxury of an equity hedge which, aside from during the initial recovery from an equity bear market, delivered a positive return.

“By institutionalising the 60/40 strategy, the industry has placed a massive bet on the market conditions that led to this strategy flourishing continuing.

The stellar returns delivered by this strategy, alongside its relative simplicity, have seen it steadily institutionalised by the investment-management industry, with the 60/40 equity/bond portfolio becoming the mainstay of multi-asset strategies. This approach was taken further by risk-parity funds, which leveraged up their bond holdings so that equity and bond allocations contributed equal risk, measured in terms of volatility, to the portfolio. By institutionalising the 60/40 strategy, the industry has placed a massive bet on the market conditions that led to this strategy flourishing continuing.

By extrapolating the past rather than adopting conscious design, the fund management industry has calibrated a structural asset allocation that thrives when disinflationary forces dominate.

But what happens if we enter an inflationary world where expectations of inflation begin to rise?

Despite the subject of inflation receiving considerable attention since the policy response to the Covid-19 crisis began, the consensus still rejects the idea that we will see a sustained acceleration of inflation in the future, believing that the forces of secular stagnation are too strong.

Inflation is considered to be inextricably bound up with demographics: we are getting older and having fewer children, thereby dooming the species to fade away in a deflationary setting.

At the same time, technological advances are such that robots and artificial intelligence are going to replace mere humans, creating a world where bread and circuses continue to get cheaper and cheaper. Furthermore, the burden of debt is a millstone that hangs around the neck of economies, keeping any nascent inflationary pressures in check.

The strength of this consensus is precisely the point. The greatest investment risk is not something that has already been imagined; it is not a recession or a eurozone crisis, a falling out between the US and China, or a bear market. The greatest risk is a failure of imagination in understanding how the game might fundamentally change.

We collectively believe we are in a deflationary world because the stock of common knowledge, accrued from our collective learned experience, tells us we are in a deflationary world.

It is hard to imagine when you are immersed in it, but the common knowledge can change. That includes common knowledge of the fundamentally inflationary/deflationary nature of our world.

Authors

Brendan Mulhern

Global strategist, Real Return team