When the consumer price index surged by 5.4% in June — its biggest jump in 13 years — Federal Reserve Chairman Jerome Powell told lawmakers he still believes prices are being "temporarily boosted by base effects." In fact, as part of his semiannual monetary policy report to Congress, he added that while he anticipates inflationary measures will likely remain elevated in the coming months, prices should moderate as supply constraints and COVID-19-related bottlenecks begin to unwind.
The prevailing question among asset owners — investors who haven't had to think about inflation for over a decade — is what this might mean for their existing portfolios and what strategic adjustments, if any, should they consider to guard against the threat of runaway inflation.
The challenge, of course, is that inflation is notoriously difficult to forecast. And whether investors plan for upside or downside scenarios, or even a base case of no change, can have a significant impact on performance or the effectiveness of specific hedging strategies. Many, for instance, took pains coming out of the global financial crisis to position their holdings for inflationary pressures that never materialized. This prolonged stretch could be likened to "Waiting for Godot," and probably felt even longer at the time as equities recouped significant losses. Hindsight being 20/20, asset owners realized that by overcompensating for what turned out to be a transitory impact, they ended up creating a new risk in the process.
While intent on not repeating past mistakes, institutional investors are today bracing for a potential inflationary impact. This is easier said than done. As it relates to any prospective hedges, investors must factor in not just the direction of inflationary measures but also the sources of price increases, the level and length of the inflationary period, whether or not it was anticipated, and the coincident level of economic growth. Policy responses from central banks represent yet another variable as would any additional stimulus. In fact, each of these developments could influence which asset classes may or may not be appropriate, but it depends on the specific combination of the aforementioned factors.
Both publicly traded equities and bonds tend to suffer when inflation increases, whether it's expected or not. This wouldn't come as a surprise to any seasoned investor. However, unexpected and persistent inflation is far more difficult to incorporate into portfolio construction. This makes scenario analysis critical to any prospective allocation adjustment, particularly as it relates to unexpected inflation, the influence of economic growth and the length of the inflationary cycle.