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Over the past year, much has been written about the macro outlook for inflation post-COVID-19, but less ink has been spilled on addressing inflation squarely from the perspective of an asset allocator. That shortage of actionable inflation insights was one impetus for this series of white papers. After all, many asset owners are arguably less concerned with how high inflation might go than with what it actually means for their investment portfolios.
While the threat posed by inflation is often clear to investors with inflation-linked liabilities, even total-return-oriented investors are susceptible to inflation risk. However, this latter cohort tends to be less focused on (and thus, less prepared for) the harmful impacts inflation can have on their portfolios. All investors can benefit from recognizing the different sources of inflation risk, gauging their portfolios’ exposure to those risks, and taking appropriate steps to manage them.
In our view, the impact of inflation on investor portfolios is felt via three different dynamics: a) the transition from a low- to a high-inflationary state; b) the level of inflation; and c) the volatility of inflation. The interplay among these three dynamics can drive a range of distinct portfolio risks of which investors should be aware (see “Inflation is a formidable foe” sidebar). Here we present a framework for investors to understand and evaluate inflation risk in their own portfolios.
The three dynamics of inflation risk
A particularly pernicious aspect of inflation is that its impact on investor portfolios typically comes from three different, but interrelated, dynamics:
- The transition from low to higher inflation (or inflation expectations) often drives immediate changes in valuations across a range of asset classes; and
- The level of inflation at any given point in time is important, with higher levels of inflation having knock-on effects for economic growth and corporate profitability.
- The volatility of inflation impacts the accuracy (or lack thereof) of inflation expectations, with greater volatility making inflation harder to forecast.
All three types of inflation risk matter for investor portfolios and, of course, can be difficult to cleanly distinguish from one another. However, given that different portfolios are likely to be exposed to them in varying degrees, it is best to be…
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