Expectations about future inflation have risen steadily over the past year and are now above their pre-pandemic level.
This led to a lively debate about the impact that higher inflation, bond yields, and the recent sell-off of some of the high-profile, fast-growing companies can have on financial markets.
No wonder the inflation is highest in 2021 than it was in the last two or three years, as it follows almost mechanically the repressed desire of many families to spend due to the pandemic of covid-19, leading to an increase in demand that runs into tight supply.
The key question investors have to ask is whether this inflation can persist beyond “reopening trade.” We believe it can happen.
In our opinion, the main force for higher inflation is the change in the policy environment, which has the potential for a more active use of fiscal instruments. It is going to be needed, as policy makers are going to have to overcome the deflationary forces that will emerge with the reopening of trade.
Policymakers are likely to prefer higher inflation to reduce the value of higher debt levels. This leads us to believe that investors will have a problem with duration, a measure of how long it takes an investor to recover the price of an asset for its cash flows.
Another way to think about duration is that it represents the sensitivity of an asset’s price to changes in returns. Thinking this way, it can be applied to all asset classes, not just bonds.
As yields have declined in recent years, the duration of high-grade bonds has increased, that is, they have become more sensitive to changes in yields, as even small movements at lower levels can have a huge impact on the time it takes an investor to get their money back. Therefore, bond investors are now more exposed if interest rates rise.
Simple cross-asset portfolios, such as those using a 60-40 allocation for bonds and stocks, have been protected from this thanks to a negative correlation in recent decades, when stocks suffered, bonds rallied, and vice versa.
If inflation rises, this is less likely to be the case. At moderate levels of inflation, bonds will sell, but stocks will be more resilient as earnings rise. But at higher levels of inflation, both stocks and bonds will be affected by the prospect of interest rate hikes.
The approach that there are more and more long-term passive investments in stocks and bonds is riskier when considered in this political environment. If fixed income no longer hedges equity risk, a new cross-asset investment model will be needed. This raises questions about many popular approaches people use to save for retirement.
Investors must adapt to have more “real” assets and act to reduce their duration risk. Real assets include physical assets like infrastructure and real estate, but public equity securities can count as real assets.
Another area that may be in demand are digital tokens of physical assets that are held on the blockchain through a network. This is a technology in the right place at the right time. But the real driver of adoption will be the demand for real assets, not the technology itself.
Any prolonged period of inflation will also support the strategy of buying undervalued companies in the market or investing in value. These assets generally have higher returns, and therefore a large part of the present value comes from short-term cash flows. So they are less sensitive to changes in long-term interest rates.
There are still many headwinds for value, especially the way technology has destroyed the “pits” that protect certain industries from competition. This leads to questions about how “value” is measured. But if higher inflation persists, value strategies may be part of investors’ response to a duration problem.