If inflation is a risk to manage, what tools do we have within portfolios to address it?
While not the most obvious hedge, equities can offer some natural protection. Companies often pass on rising input costs to their customers through higher prices. There isn’t necessarily a mechanical link however, and the ability of companies to pass on higher costs (rather than absorb them through margin) depends on their unique and sectoral pricing powers.
Commodities are a more obvious inflation hedging asset class. Clearly, commodity prices have a more direct impact on inflation and so their hedging benefit is more direct. But they come with high volatility and carry costs, and this reduces their attractiveness as a long-term hedge.
Inflation-linked bonds are also a more traditional hedge for inflation: these instruments adjust their principal and interest payments in line with inflation, so their value is maintained in ‘real’ terms (i.e. after inflation). When comparing the yield of index-linked bonds and traditional nominal bonds, it is possible to identify a ‘breakeven’ rate, which is a measure of market-based inflation expectations.
Interestingly, index-linked gilts today have a breakeven rate at around 3% over the next decade (i.e. the market is expecting inflation to average 3% per annum over the next ten years). This is the lowest implied rate we have seen since late 2021. Breakeven rates of this level were seen in the notoriously low-volatility post-GFC period of 2010 to 2020. Could this view be overly optimistic? With structural inflationary pressures such as deglobalisation, climate change, fiscal expansion and fast-moving political dynamics still in play, the asymmetry in inflation risk appears to us to be skewed to the upside.
Whether or not inflation does come back to the fore, we believe it is a crucial risk to manage. In a world where inflation may not behave as it once did, there is a role to play for both direct and more indirect forms of inflation protection within portfolios.
