Financial markets at risk if inflation remains high for a long time. Generally, high inflation results in higher interest rates, which can lead to a sell-off in bond markets. According to T. Rowe Price, US short-term inflation will be higher than in the past decade, but not enough to be a major concern. Recent inflation data has been heavily influenced by the extreme price hike in sectors that have seen an abrupt halt and subsequent recovery due to the pandemic, such as cars and travel.
Positioning the portfolio in light of potentially persistent inflation is possible in three ways as experts indicate.
Three ways to protect portfolios from inflation
First, you can protect your portfolio from inflation by purchasing inflation-linked sovereign bonds (ILBs). Designed to help investors protect their portfolios from inflation, ILBs are indexed to the price level, so principal and interest payments follow the trend of inflation. One problem is their cost, which is high in many markets. This means that they offer low or negative inflation-adjusted returns, leading to a risk of negative total returns in real terms. Most importantly, ILBs outperform standard nominal government bonds of similar duration only if effective inflation is higher than the breakeven inflation rate (reflected in the difference between the yield on nominal bonds and ILBs). Now, the breakeven rates are quite high, which makes it difficult for ILBs to outperform.
Second way, invest in cyclical stocks, which tend to perform well in a context of rising prices. Generally, inflation rises in times of economic expansion, when cyclical assets are doing well. These include value stocks, small cap stocks, and Japanese, European and emerging market stocks.
Third, by buying high yield assets with a relatively short duration, such as global high yield bonds and emerging market debt. The higher returns represent a buffer to add to total revenue, compared to redeeming traditional coupons. The two caveats are the fact that both assets are linked to equity markets, and therefore do not diversify risk, but also involve credit risk at the same time, thus making credit analysis necessary to mitigate losses.
According to Yoram Lustig, Head of EMEA Multi‑Asset Solutions e Michael Walsh, Multi‑Asset Solutions Strategist, T. Rowe Price, il The advantage of the investment ideas in points 2 and 3 is that they should perform well during periods of high and low inflation, not necessarily during periods of high inflation. In other words, they could provide inflation protection without the cost of reducing expected revenues. Since it is impossible to be certain about the level of inflation in the coming years, investment strategies such as those listed could be particularly useful.