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Central banks may win the near-term battle against rapidly rising prices, but over the longer term we think inflation will be a tougher opponent than some expect. With this in mind, asset allocators should look for opportunities to reinforce their inflation-hedging defenses.
Inflation is likely to moderate from last year’s sky-high levels in coming months — a result of the lagged impact of monetary policy tightening and a more challenging environment for credit given bank lending and liquidity concerns. We’ve already seen inflation come down in some of the more variable areas of the CPI, as measured by the Federal Reserve Bank of Atlanta’s Flexible Price CPI — an index that includes prices of food, autos, apparel, and other goods and services that are more immediately responsive to changes in the current economic environment or the level of economic slack (light blue line in Figure 1).
But looking further out, we expect inflation to be higher over the next decade than it was over the previous one. In fact, even as flexible inflation has waned a bit, “sticky inflation” appears to have taken hold, based on the so-called Sticky Price CPI (dark blue line in Figure 1), which includes many service-based categories, such as medical services, education, and personal care services, as well as most housing categories — i.e., categories of the CPI that tend to change more slowly over time.
We see a number of reasons to expect structurally higher inflation:
For asset allocators who agree with our inflation outlook, we think there are a number of investment ideas worth considering, including:
Adding real assets — Commodities have historically had a high beta to inflation, making them a potentially potent hedge. Those who aren’t comfortable investing directly in commodities might opt for a diversified real asset portfolio that includes, for example, commodities, natural resource equities, and TIPS.
Tilts to inflation-sensitive sectors — Within an equity allocation, there may be opportunities to add to natural resource equities, as well as other inflation-sensitive equities such as listed infrastructure (where companies can often pass inflation directly to their rate payers). In addition, value stocks, given their lower sensitivity to interest rates, may behave better than growth stocks in an inflationary world.
Risk management at the portfolio construction level — If we assume higher inflation ahead, and therefore higher interest rates, then allocators may not be able to rely on bonds for consistent diversification — that is, we could see more periods in which bonds and stocks are positively correlated as they were in 2022. This may call for new sources of diversification, including using certain hedge funds as a complement to fixed income (a topic our colleagues discuss in more detail here).
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