Inflation: The Only Question That Matters

For a decade now, the behavior of all investors has been predicated on the belief that there is no chance of a sustained acceleration of future inflation.

Ultimately, determining whether we are living in an inflationary or disinflationary world is the most fundamental question that long-term investors must get right, and will have repercussions in terms of the type of investment strategies that thrive. The most pervasive and powerful piece of received wisdom in investing has been the view that we are destined for a future of low growth thanks to too much debt and demographic trends.

If we look at the US alone, the fiscal deficit has been deteriorating for years. After 40 years with average and current account deficits of around 3%, the US fiscal deficit is now set to run at double digits for some time, as the US Budget balance as a percentage of nominal GDP shows below:

Exhibit 1: US Budget Balance (% of Nominal GDP)

Source: Bloomberg, June 30, 2021

The asset-management industry has calibrated a structural asset allocation that thrives when disinflationary forces dominate.

Investing in a disinflationary world has been a relatively straightforward affair. Both equities and bonds – the mainstay of investment portfolios – have been in structural bull markets for two generations.

Furthermore, equity and bond-market returns have been negatively correlated, particularly around turning points in the economic cycle.

This made portfolio construction easy: the lion’s share of a portfolio was dedicated to equities, and in order to hedge against equity bear markets, a substantial portion of the portfolio was allocated to government bonds. (See the long-term decline in 10-year US Treasury yields over the last 40 years in the chart below).

Exhibit 2: US 10-Year Treasury Yield

Source: Bloomberg, May 31, 2021

By institutionalizing the 60/40 equity/bond portfolio strategy, until relatively recently, many asset managers placed a massive bet on the market conditions that led to this strategy flourishing continuing.

The stellar returns delivered by this strategy, alongside its relative simplicity, have seen it steadily institutionalized by much of the asset-management industry. This approach was taken further by risk-parity funds, which leveraged up their bond holdings so that equity and bond allocations contributed equal risk, measured in terms of volatility, to the portfolio.

By extrapolating the past rather than adopting conscious design, the asset management industry has calibrated a structural asset allocation that thrives when disinflationary forces dominate.

But what happens if we enter an inflationary world where expectations of inflation begin to rise?

Inflation is considered to be inextricably bound up with demographics: we are getting older and having fewer children, thereby dooming the species to fade away in a deflationary setting.

At the same time, technological advances are such that robots and artificial intelligence are going to replace mere humans, creating a world where bread and circuses continue to get cheaper and cheaper. Furthermore, the burden of debt is a millstone that hangs around the neck of economies, keeping any nascent inflationary pressures in check.

The strength of this consensus is precisely the point. The greatest investment risk is not something that has already been imagined; it is not a recession or a eurozone crisis, a falling out between the US and China, or a bear market. The greatest risk is a failure of imagination in understanding how the game might fundamentally change.

We collectively believe we are in a deflationary world because the stock of common knowledge, accrued from our collective learned experience, tells us we are in a deflationary world.

It is hard to imagine when you are immersed in it, but the common knowledge can change. In our new paper 'A monetary regime change or just a mild bout of inflation?' we address the issue of inflation and explore how a robust, balanced portfolio could be structured to navigate such an environment.

Read the full paper

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