From anchored to unanchored inflation expectations — In recent years, the inflation expectations of consumers and the market have been fairly well anchored at no more than 2%. I’ll be watching to see whether that expectation is replaced by much greater uncertainty about where inflation is going long term.
From idiosyncratic to self-reinforcing inflation — The question here is whether we’ll move from idiosyncratic inflation that’s linked to the business cycle or a post-COVID boom, for example, to self-reinforcing inflation resulting from a wage/price spiral or a falling US dollar.
How could it impact markets and positioning?
From a market standpoint, our research suggests that we would see both a near-term impact from high inflation, including a repricing of equities, and a longer-term impact, with valuations taking a hit and earnings growth declining as companies struggle to pass inflation through to consumers or to manage the impact of inflation volatility.
In terms of positioning, real assets and commodities would seem the logical place to start, given their historical sensitivity to inflation. Within equities, there may be a case for preferring inflation-sensitive sectors and value stocks; the latter have tended to perform well in inflationary periods (e.g., the 1970s) and to be impacted less by higher rates due to the typically shorter duration of their cash flows. Non-US equities may also be interesting. For example, in Europe and Japan, we could see rates go from negative to positive, and that may not be a bad thing for those equity markets. Gold is considered a classic real asset, of course, though to some extent that view is anchored to the strong performance of the metal in the 1970s, a period when not many assets held their value.
Figure 3 shows the beta of different asset classes to changes in inflation, proxied by breakevens and going back to the late 1990s. Commodities, including crude oil and industrial metals, had the highest beta to inflation, while duration, especially in Treasuries, had a negative beta to inflation. Equities actually had a modestly positive beta to inflation, but that’s because the period studied was a low to moderate inflation regime (a good inflation period, not a bad one). I wouldn’t bank on broad equity markets holding up if inflation becomes the driving force in the current market environment.