Fuelled by rising energy prices, soaring monthly inflation figures have reached highs that were unheard of in the last 20 years. Combined with the extraordinary policy measures central banks have employed since the Global Financial Crisis in 2008, this has forced central banks into a balancing act.

Looking forward, we can hypothesise three representative scenarios of how this balancing act could pan out. Firstly, “good” inflation, whereby the rise in inflation would be coupled with a swift recovery of labour markets and overall productivity.

This situation would be much like the scenario that presented itself in 2021, even leading to labour shortages in certain sectors. Here, inflation occurs in a constructive growth environment and central bank complacency is continued.

If inflation maintains its bullish face, equities should be expected to be clear winners. For bonds, gains from tighter spreads in the “good” inflation scenario cannot offset higher rates and continued negative real yields raise the opportunity costs of bond investing.

Inflation-linked bonds, widely available as an ETF investment vehicle under a UCITS umbrella, could partly defy this trend. Inflation-linked bonds are indexed to inflation meaning the principal and interest payments move in tandem with the rate of inflation, serving to alleviate the eroding power of inflation to investors’ purchasing power. But investors should be aware that a contrastingly “bad” inflation could likely arise, encompassing such omens as supply disruption.

Here, inflation in this scenario acts as a destructive factor as inflation and growth move in opposite directions. Going against conventional wisdom, safe-haven assets provide inflation protection in this scenario meanwhile inflation-linked bonds would benefit twofold from falling rates and rising inflation.

Delving further, with a particular focus on central bank policy, a third shade of inflation – “ugly” – could emerge as well. Here, central banks would choose price stability over economic growth and hike even in times of a clouded economic outlook sending markets into a downward spiral. Equity markets suffer from bear market expectations while sovereign, as well as corporate bonds, are hit by higher rates and spreads.

Having identified the three shades of inflation and their respective differences, a common denominator becomes apparent: the integral driving role of central banks in controlling the translation of inflationary pressures into inflation itself.

This comes into play directly with the suitability of inflation-linked bonds which are most responsive to breakeven inflation – the market consensus of expected inflation – measuring the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. In this way, causality between inflation risks and central bank action may drive investor sentiment.

With hindsight, inflation has been a symptom of recovery in 2021. In 2022, it may cause market demise instead with significant geopolitical tensions at play surrounding Russia’s invasion of Ukraine and the consequent volatile oil prices, having recently seen record highs since 2008.

In the absence of a ‘one size fits all inflation solution, market participants need to remain agile and reactive to the tools available to them while cognisant of their suitability in the current environment.

Keshava Shastry is head of capital markets at DWS, chair of ETF task force at EFAMA and chair of the ETF committee at the Investment Association

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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