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Positioning for Inflation

The strongest U.S. inflation in decades has triggered stock volatility and uncertainty about how the Federal Reserve will react. Chief Investment Strategist Jim McDonald discusses the inflation outlook, which asset classes have performed well during inflationary periods, and how we’re positioned.

  • Higher Inflation Supports the Fed’s Case
  • Inflation Outlook
  • The Performance of Asset Classes During Inflationary Periods
  • Prepare for Further Volatility

 

Transcript

[MUSIC PLAYING]

After a fairly placid year in equity markets last year, volatility has been on the rise due to the usual suspect, uncertainty. The rise in uncertainty is mostly tied to surging inflation, which has been an issue the markets handled with relative equanimity in 2021. Let's take a closer look.

Maybe this is like the old story about boiling the frog, and the water has now gotten to the boil. In December, we hardened our risk case around inflation from a Federal Reserve overreaction to Fed hawkishness justified by persistent inflation. The US headline inflation rate of 7 and 1/2% in January bolsters this case. We now expect three hikes by midyear before the outlook becomes a bit more cloudy, but we would be surprised if the Fed actually accomplished the six rate hikes currently priced in by the markets.

We've regularly discussed the historical performance of key asset classes during the first year of Fed rate hike cycles. Well, history shows a persistent trend of positive performance. There is a pattern of softness in the early months of the campaign. This current episode is undoubtedly being influenced by the strongest inflation in decades with inconclusive evidence of coming relief in supply bottlenecks, which have boosted goods prices.

We're expecting this to start coming through by midyear, which will be necessary to offset the potential of continuing strength in labor and housing markets. Recent improvement in the US West Coast shipping wait times and comments from ocean shipping companies are hopeful, but could prove premature.

As investors, our job is to position portfolios for the economic environment we see unfolding while also ensuring client goals can be met. So what asset class has performed well during inflationary periods? Performance last year gives some clues, with developed market equities, natural resources, real estate, high yield, and TIPs all good performers. Conversely, investment grade and emerging market bonds struggled. Our current global policy model recommendations reflect these trends.

Volatility is likely to remain high as solving the supply and demand imbalances leading to the current high global inflation won't be immediate. However, inflation expectations in the market have been reasonably well-behaved as the expected rate of inflation over the next five years remains below 3%. Other global risks, like the potential of a Russian invasion of Ukraine, remain on watch, but are too unpredictable to warrant action in portfolios. Thankfully, the increased relaxation of COVID-19 policies globally further reduces the economic risk around the pandemic and provides further runway for the complete reopening of the global economy.

Jim McDonald

Chief Investment Strategist
Jim McDonald is an executive vice president and the chief investment strategist for Northern Trust. He is responsible for overseeing the strategic and tactical asset allocation policy for our institutional and wealth management clients globally.