Anybody on a fixed income knows all too well that high inflation means a drop in living standards. So the recent pickup of inflation has investors asking if we are on the verge of a new era that justifies a new investment approach. This leaves investors facing one of two risks, depending on what happens with inflation and how portfolios are positioned.

The first risk is that investors fail to prepare for high inflation and find their income and wealth fall in real terms. The second risk is that investors mistakenly prepare for higher inflation only to find inflation stays low, and they then suffer unusually large losses in the next economic and profits crisis because they have sold all their defensive assets that can offset large equity losses.

So what can we tell about the future of inflation from the data? The December CPI data shows headline annual inflation jumped from 5.1% in November to 5.4%, its highest level in 30 years and far above the Bank of England’s 2% target. Key drivers of rising inflation include the increase in prices for oil and gas, motor vehicles, accommodation and catering services.

The BoE has emphasised the temporary nature of many key contributors due to “base effects” (temporarily depressed price levels of 12 months ago), increase in VAT, supply disruptions related to COVID-19-induced lockdowns and the global synchronised rebound in demand.

It expects inflation to peak in 2022, and within two years, to be a little above the 2% target, noting that “some modest tightening of monetary policy” is likely to be necessary.

Crystal balls are cloudy

Of course, we do not know with certainty what will happen. The BoE has forecast an increase in the peak inflation rate as new information has become available. On the one hand, you can argue that inflation is more likely to fall back into its 25-year range of 1%-3% over rolling three-year periods as the demand and supply effects of the COVID-19 pandemic unwind.

This assumes demand eases back from the supercharged recovery as governments rein in spending and raise interest rates from historic lows. It also assumes a more even global economy with not all regions experiencing strong demand at the same time.

On the supply side, it can be argued that the bottlenecks in global shipping, port capacity and shortages of semiconductors and manufactured goods may ease as lockdowns become less frequent and both manufacturing and investment pick up. People who left the workforce may be tempted back by rising wages, with the end of furloughs being a further incentive.

The case can also be made that high inflation is becoming more – not less – likely. Central banks have tweaked their mandates to be more tolerant of inflation overshooting targets and kept in place extreme levels of stimulus, even in the face of surging inflation pressures and economic rebounds.

The ingredients are present for a policy mistake with high levels of debt incentivising authorities to keep interest rates as low as possible for as long as possible in order to prevent a blowout in interest payments. Government spending also remains very large in the UK and most major economies.

Also, more government spending is needed to meet carbon emissions targets. Temporary shortages are lasting longer than expected for two essential inputs to traded industrial and consumer goods: container shipping and semiconductors. Both are putting upward pressure on costs and prices. All of this has propelled inflation to the upper end of the range for the past quarter-century of 1%-3% per annum.

Even so, we are still some way off the levels of inflation that have troubled investors in the past. Our own long-term studies showed that when UK inflation averaged 4%-6% per annum, multi-asset portfolios suffered as equity returns failed to keep up with inflation. The transitions to these high inflation eras coincided with more than just powerful economic recoveries. There were either wars or revolutions that smashed trade and created scarcity, or fundamental shifts in government policy away from keeping inflation low and stable.

Eventually, consumers and businesses upped their expectations of future inflation and set in motion self-reinforcing cycles.

Accurate forecasting unlikely

High inflation outbreaks are uncommon, and your chances of correctly forecasting such big structural shifts are not high. What makes it challenging is the complexity of our highly integrated, multi-polar global economy and the slow-moving nature of structural changes.

There is scant evidence of forecasters getting these big calls right, and far more evidence of them getting it wrong.

So instead of basing your investment strategy on an inflation view, you can use two strategies to tilt the odds in your favour. The first is to bias portfolios to better value opportunities that have a bigger margin of safety priced in. These investments are more likely to provide higher returns and offset higher inflation. Energy equities, UK equities and emerging market bonds flag in our research as attractive and feature in our Morningstar managed portfolios and multi-asset funds.

The second strategy is to test portfolios for a wide range of different economic and market scenarios, not just high inflation. This can reveal which scenarios are best and worst for performance as well as less obvious sources of diversification.

From this type of analysis, we can still see a role for high-quality government bonds in specific deflationary shocks. Foreign currency is also effective as a diversifier against UK-specific inflation risks such as Brexit-related impacts on labour costs and imported goods prices.

So while inflation pressures are building, the hallmarks of a high inflation environment are not unequivocally present today. Instead of trying to guess what inflation will do next, investors are better served by building portfolios of the most attractively valued investments they can find and the least expensive diversifiers.

Mike Coop is CIO, EMEA, at Morningstar Investment Management

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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