Inflation has emerged as a lasting challenge reshaping the investment landscape. While central banks around the world have begun cutting interest rates, it is no longer clear how long they will be able to continue doing so if inflation expectations continue to bounce back.
The latest jump in the US 10-year Treasury yield suggest renewed long-term inflation fears.
Fears over inflation remaining high for longer have rapidly resurfaced being driven by better-than-expected growth forecast globally and particularly in the US, embracing the ‘soft-landing’ scenario.
Why could inflation stay higher for longer?
These are the primary reasons in our view, shaped by government policies:
- Re-shoring & Friend shoring, moving chains of production home or to foreign partners due to government economic incentives (i.e. the US’s Chips Act, Inflation Reduction Act etc.) tend to be inflationary. This deglobalisation, also enhanced by geopolitical tensions tend to increase production costs and thus lead to higher inflation.
- Tariffs: The threat of tariffs or actual tariffs or negative consequence from moving production overseas has caused inflation as ultimately the consumer pays the tariffs as businesses are forced to increase their prices.
- Energy transition efforts are fuelling a boom in critical commodities such as lithium, copper, and rare earth metals. But more recently, the AI revolution and its associated infrastructure being built is creating enormous demand for electricity, pushing up prices.
- AI, data storage and analytics consumes enormous amounts of energy, and it is in fact proving expensive and in turn inflationary.
- Both AI and the energy transition divert key resources from other areas of the economy, adding to possible workers shortage.
- Government support such as subsidies to encourage the energy transition also help fuel demand, adding to inflation.
- In essence, consumers will likely pay for AI-services in their bill, just like smartphones increased the cost of using a phone, by creating a new product many see it then as a new necessity, accepting a larger monthly expense.
There are historical precedents of multi-year inflationary waves.
Markets strategists are increasingly sharing the view that there are structural drivers that could lead a new inflationary wave. In the example below, Gavekal Research reviews the inflation waves of the 1970s, although today the structural drivers of inflation are somewhat different in nature.
With those elements in mind, let’s explore what are the assets that may do well in today’s current environment, that may be associated with high inflation.
What investments could do well in an inflationary environment?
1. Quality stocks with pricing power and dividends
- Stocks with above average profit margins, low debts, and a high return on capital invested should do well as those businesses are able to raise prices to counter inflation. On the contrary, businesses which are price takers and burdened by debt should find it more difficult as their cost of capital increase.
- Stocks with growing cash flows and dividends should perform above-average in an inflationary period. Typically, those businesses have ‘quality’ factors such as: a strong moat, high brand power, and that are unique in the sense that their products or services are in high demand and the clear market leaders should do well.
- In terms of sector, quality stocks tend to be asset-light businesses and those in strong demand i.e. beneficiaries of the AI infrastructure build, but not only.
2. Precious Metals – Gold has performed exceptionally well as a hedge against global uncertainty and currency devaluation. Today it is particularly sought after by large investors and central banks. Historically it has done well during risk-on inflationary environments. With a higher volatility, silver may also be sought after for both its industrial metal features and as a store of value.
Chart showing the performance of stocks, quality stocks, and gold since 2006.
Neither expected return nor past performance is indicative of future performance. Actual results may differ.
3. Real Assets, tied to Rising Rents
- Real estate tends to retain its value during an inflationary period. For one demand tends to be sticky and cost of construction tend to rise supporting prices. In the stock market, high-quality REITs could be an alternative. The pricing power in terms of ability to rise rents in periods of inflation should be key.
- Infrastructure assets should also perform well for its strong demand and rent component, so long as the asset is able to increase the rents with inflation.
4. Fixed income: Short-term, Inflation Protected or Floating
- Inflation-linked bonds: bonds with coupons linked to inflation
- Credit short-term maturities: debt with short-term maturities can be regularly rolled over, thus limiting the risk of capital loss in a rising interest rates environment
- Loans / debts – with floating coupons to mitigate the risk of rising rates
Finally, portfolio diversification is critical to navigate a period of higher inflation and the volatility of the different assets classes that may be associated with periods of high uncertainty. As illustrated in the chart above, for instance simply having gold and stocks together in a portfolio could have already provided some degree of diversification.
Conclusion
In conclusion, investing in a world of persistent inflation requires a strategic shift in mindset and portfolio allocation, considering future demand and pricing power of various assets. As we live in a world of ample liquidity and loose monetary policies, considering the risk of inflation remaining higher for longer should be key for long-term capital preservation.
This article is brought to you by the Advisory Solutions Team.