Commodity futures, oil and gold have demonstrated inflationary resilience but the major risk of over-reliance on commodities for inflation hedging comes in the form of muted or negative overall risk-adjusted performance over longer-term time frames. These traditional long-only assets are unlikely to be enough for an effective stagflation solution.
A more robust stagflation solution needs to extend beyond traditional long-only assets and focus on the following:
A well-balanced combination of alternative investment strategies may allow one to benefit from varying dynamics across asset classes without being overexposed to inflation risks.
Strategies with sound theories or evidence surrounding their ability to perform during inflationary regimes. Examples would be multiasset cross-sectional models harvesting relative carry effects — particularly in fixed income, foreign exchange and commodities.
Strategies that should not necessarily rely on U.S. growth only and should be implemented globally in a scalable and liquid manner. An example would be a global, multiasset, long/short, directionally unbiased (not long- or short-biased) liquid trading strategy that is not heavily weighted on U.S. equities or U.S. fixed income, either a globally diversified multiasset trend strategy or a multiasset global short-term tactical trading strategy.
A good solution needs to not fail catastrophically should stagflation not materialize. So while we expect trend following to work well in a stagflationary environment, it is also able to navigate non-stagflationary environments. Additionally, one ought to consider the possible ancillary effects of likely central bank actions that seek to combat inflation or the mere threat of significant inflation. Central banks could choose to let inflation run for a while as that will erode their debt obligations, but eventually that inflation will need to be addressed — most likely via significant rate hikes.
Higher interest rates have been known to hurt commodities such as gold due to the increase in opportunity cost as gold does not yield anything. Trend-following strategies on the other hand can navigate rising yields by unbiasedly capturing directional opportunities wherever they occur, including shorting bond futures.
We can only speculate on how central banks would react to a revival of inflation, but it's not inconceivable that inflation will not manifest itself everywhere at the same time and that could very well create global central bank policy divergence, thus leading to new and varied dislocations throughout the global cross-section of term structures within asset classes that could be harvested by relative carry models.
A final ancillary effect that we would like to highlight is the potential for market instability during periods of stagflation.
The addition of shorter-term strategies designed to capture opportunities in expanding volatility environments — whether these strategies are operated on liquid futures or option markets — would offer useful complementary performance to traditional assets in the early stages of market instability — regardless of the source of the market instability.
Razvan Remsing is director of investment solutions and Hakeem Gbadebo is an investment solutions analyst at Aspect Capital Ltd., London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.