The acceleration of price increases since early in the pandemic, coupled with heightened geopolitical tensions, has focused investors squarely on the risks of inflation for the first time in decades. Unfortunately, current higher inflation comes at a time when bond yields are exceptionally low and equities are at elevated valuations, leaving markets particularly vulnerable should central banks need to execute an aggressive monetary tightening campaign. In this environment, we believe that investors should consider a fresh approach to inflation in portfolios, to both help mitigate and benefit from its potential impacts through the use of a range of asset segments and strategies. We lay out our ideas below.
New Dynamics Restore an Age-Old Issue
In modern industrial economies, moderate inflation has typically been considered a positive. It encourages consumption and investment, which stimulates the broader economy. During economic slowdowns, it enables central banks to cut interest rates below the rate of inflation without having to go all the way to zero.
In contrast, low inflation and deflation can be symptoms of an unhealthy economy, with subdued consumer demand and excess capacity, while persistent high inflation raises costs for businesses and consumers, and can ultimately lead to widespread economic hardship—threatening a “vicious cycle” as investment in productive capacity is increasingly withdrawn. Such a pattern is one that policymakers and most investors are hoping to avoid.
The 2020 COVID-19 lockdowns were initially disinflationary as consumers saved at unprecedented rates. However, the trend reversed as governments supported businesses and workers. Reassured, consumers began to spend before many workers had returned to their jobs, while emergence from lockdowns accelerated recovery. Still, the waning pandemic left the world with fragmented and under-resourced supply chains, which were unable to meet the wave of pent-up demand. Across Europe and the U.S., inflation hit levels unseen since the 1980s, which forced central banks to take a much more hawkish stance, even as the Ukraine conflict and sanctions against Russia later suggested a dampening of the immediate path toward higher interest rates. With prices rising at nearly a double-digit pace, monetary policy is likely to eventually involve removal of quantitative easing and a series of rate increases.
Inflation Surges to 40-Year High
U.S. Consumer Price Index, Year-Over-Year Change
Source: FactSet, through March 2022. For illustrative purposes only.
More Inflation = More Volatility
In our view, much of the supply-chain disruption associated with the pandemic is likely to subside as companies adapt and bring more workers on board, while the current extreme inflation is unlikely to last. Still, we see several reasons why it could remain higher than many have been used to over the last two decades.
Deglobalization. Supply-chain disruptions have been painful enough for companies to begin localizing and diversifying operations, complementing the “just-in-time” arrangements of the past 40 years with more “just-in-case” redundancy. Governments are also encouraging reshoring for security of supply, particularly in strategic goods such as semiconductors.
China. The country’s decades of exported disinflation appear to be over. Its population is aging, barely growing and more urbanized, with the government now prioritizing equality, health, the environment and automation over job-generating growth.
Policy. Central banks appear to be deprioritizing price stability in favor of social goals like sustainable infrastructure, full employment and economic equality, while governments are adopting more populist economic policies that tend to be more inflationary.
Decarbonization. The transition to renewable energy and an electrified economy will likely be costly, and involve cutting investment in carbon-intensive energy even as the supply of renewables remains limited. In our view, the transition will likely generate “greenflation” in energy commodities and the metals needed by the net-zero economy.
Although longer-maturity bonds have been adjusting, we believe they are still not priced for structurally higher inflation. The Federal Reserve seems interested in moving real yields (excluding inflation) back to zero, which would require a decline in inflation expectations or a rise in nominal (including inflation) long-dated yields, or both.
That leaves financial markets vulnerable, in our view. A decade of slow global growth, zero interest rate policies, quantitative easing and the subsequent search for growth and yield resulted in unique market dynamics, including low fixed income yields, small yield differences between Treasuries and other bonds, high equity valuations and exceptional demand for growth stocks. This, in turn, has put many stocks and bonds at expensive levels, increasingly correlated to one another (reducing the diversification benefit of bonds) and potentially sensitive to changes in interest rates should the Fed need to accelerate monetary tightening. In addition to geopolitical factors, the volatility that has opened 2022 reflects this market fragility, as well as the potential for a less favorable growth-inflation mix than faced in recent decades.
Bond Yields Remain Low and Sensitive to Tightening
Yield and Duration (Rate Sensitivity)
Source: FactSet, data through April 14, 2022. Bloomberg Barclays Global Aggregate Bond Index. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Growth Concentration Has Made Indices More Vulnerable
Top Five Stocks’ Proportion of Index Market Capitalization
Source: Bloomberg, data as of December 31, 2021. For illustrative purposes only. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
What Might This Mean for Portfolios?
In our view, investors should look to deal with inflation not just through the lens of fixed income, but from a multi-asset class perspective, which capitalizes on varied diversification, income generation and appreciation potential of different asset classes to maintain an aggregate portfolio that is reasonably insulated from inflation (among other risks) and can build wealth even when rising prices are taken into account.
From a tactical perspective, we believe investors preparing for structurally higher inflation should seek to achieve three things:
- Mitigate against inflation by shortening duration or exposure to interest rate fluctuations.
- Take advantage of inflation through exposure to companies with pricing power as well as the ability to generate more earnings and income as inflation increases; and, in fixed income, look to floating-rate yields and shorter maturities, and include allocations to real estate and other “real assets.”
- Diversify by weighting portfolios more toward value and away from inflation-vulnerable growth stocks, adding to income-oriented and quality equities, and looking to strategies with lower correlations to major market indices.
We would argue that seeking out inflation-sensitive assets today is not only about capturing inflation, but broader portfolio diversification, as many investors may lack sufficient inflation exposure after years of stable prices.
Fixed Income: Shorter Maturities, Floating Rates, Flexibility
Among the asset classes, fixed income portfolios are arguably most at risk in an inflationary environment. Inflation and higher interest rates lower the present value of future income streams, thus particularly affecting longer-dated bonds. Here we think the priority should be to mitigate against inflation, drawing on various segments within the fixed income universe and capitalizing on the benefits of active management, which can reduce exposure to more vulnerable indices, and seek to achieve more opportunities for generous income levels.
- Shorter maturities: Minimizes the impact of rising rates by investing in bonds with less sensitivity to fluctuations in interest rates.
- Non-investment grade: To maintain yield with less interest-rate risk, consider high yield bonds, short-duration high yield, bank loans and securitized debt. Moving down in credit quality has historically provided yields that offer more insulation from inflation (see display), albeit with greater risk from individual security fundamentals.
- Municipal bonds: Keep to shorter duration, with somewhat lower credit risk.
Inflation-Adjusted Yields Across Fixed Income Sectors
Source: Neuberger Berman, Bloomberg, JPMorgan. As of March 31, 2022. Benchmarks used are EMD Blend Index (50% JPM EMBI Global Diversified and 50% JPM CEMBI Diversified), U.S. HY (Bloomberg U.S. Corporate High Yield TR Index Value Unhedged), U.S. IG Credit (Bloomberg U.S. Corporate Total Return Value Unhedged USD), U.S. Muni (Bloomberg Municipal Bond Index TR Value Unhedged USD), and U.S. Agg (Bloomberg U.S. Agg TR Value Unhedged USD). Inflation represented by U.S. five-year inflation breakeven rate. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Although generally challenging for bond portfolios, there are ways to take advantage of inflation.
- Treasury Inflation Protected Securities (TIPS): Short-dated U.S. TIPS were among the few bond markets where total returns matched the 7% U.S. inflation rate in 2021, but we believe they are now expensive—making it prudent to watch real yields (after inflation) for a more attractive entry point.
- Floating rate securities: Segments including bank loans and private credit have been outperforming due to their short duration—and rising coupons may add to their total return outlooks once central banks embark on their projected rate hikes.
Bond markets offer ample ways to diversify risk: via duration, credit (i.e., non-Treasuries), currency, region, fixed or floating rates, and senior or subordinated positions in capital structures.
- Flexible strategies: Current uncertainty may lend itself to “go anywhere” strategies that are able to shift with economic data and investor sentiment.
Equities: Pricing Power, Renewed Focus on Yield
Stocks have historically performed well during periods of moderate rising inflation, likely due to the strong economic growth that often accompanies it. However, as inflation becomes more extreme, this relationship can break down as monetary tightening and softer growth may cut into earnings.
Equities Have Tended to Benefit in Moderate Inflation Regimes
Source: Bloomberg. January 1972 – January 2022. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
The potential for a less favorable growth-inflation mix (weaker growth and higher inflation) is good reason to re-examine style and sector tilts in equity allocations, and also to rethink exposures to passive strategies that offer less ability to distinguish among corporate fundamentals.
Just as with bonds, to mitigate against inflation in equities it’s possible to minimize the negative impact of rising rates.
- Value stocks: Are generally less sensitive to interest rate fluctuations than growth stocks, whose earnings outlooks are more weighted to the future.
- Equity income: Companies that pay a large share of their profits as dividends provide cash flows that can also be less rate-sensitive.
To take advantage of inflation in equities, it may be helpful to think of markets in terms of “upstream” and “downstream” businesses, among which active managers may adjust their exposures.
- “Upstream” businesses: Commodity producers, real-asset owners, semiconductor manufacturers, banks and capital goods manufacturers generally find it easier to pass on their costs than “downstream” business, such as retail.
- Luxury goods and leisure: Although technically “downstream,” companies in these sectors may see their price hikes more easily absorbed by their consumers.
- Cyclical stocks: Many upstream and midstream businesses are cyclical—they could be at risk from lower economic growth, but current low valuations may provide a buffer.
To diversify an equity portfolio implies defensive positioning.
- Defensive quality: Sectors such as consumer staples and health care are downstream businesses with limited pricing power, but current low valuations may provide a buffer against the potential impact of inflation, and many are longstanding payers of steadily growing dividends, which may reduce their interest-rate exposure and improve their resilience against inflation.
Alternative Investments: Real Assets, Uncorrelated Strategies
Historically low bond yields, tight credit spreads and high equity market valuations raise the likelihood that stocks and bonds will become more correlated and more volatile. In our view, the potential for structurally higher inflation and a less favorable growth-inflation mix increases that likelihood still further. We think alternative diversifiers will need to play a more prominent role, with a focus on those with particular sensitivity to inflation.
Real assets are often the heart of portfolios designed to take advantage of inflation.
- Commodities: Deglobalization and geopolitical disruptions are likely to increase global competition for commodities; the policy focus on equality implies greater spending power for those on lower incomes, who tend to spend more on commodities; and de-carbonization is likely to increase demand for many commodities, especially metals.
- Real estate: As construction costs rise, the value of existing real assets also tends to rise; to justify construction costs, rents across the sector are likely to have to rise, too; many sectors have longer-term leases with contractual inflation-linked escalators, others have annually renewable leases, with rents rising and falling with consumer prices and wages.
- The spread of professional management across public and private real estate has expended opportunities for return and risk mitigation across a still fragmented landscape.
- Infrastructure: Long-term usage contracts often adjust in line with a producer or consumer price index or, in the case of a utility, the price of its commodity feedstock; other assets are often critical enough to have considerable pricing power.
- Master Limited Partnerships (MLPs): Listed companies that specialize in managing midstream energy infrastructure assets
In our view, high valuations, low yields and the potential for a less favorable growth-inflation mix make the need to diversify equity and bond risks greater than ever.
- Private equity: Valuations of existing underlying assets may be at risk because they tend to be growth-oriented and long-duration, but fund commitments made today are likely to be invested over the coming two to three years, potentially benefitting from more attractive valuations.
- Uncorrelated strategies: Low correlations can potentially be achieved through long and short positions that create market-neutral exposures, as with relative-value and market-neutral hedge funds; or via short- and medium-term trading, as with macro or trend-following strategies.
- Equity index put-writing: This approach can earn premiums that have tended to rise during times of market uncertainty and volatility by effectively selling insurance against substantial drops in equity indices.
- Gold and digital assets: While it can be vulnerable to rising rates, gold has a history of strong performance when the growth-inflation mix is unfavorable; Bitcoin’s built-in scarcity could give it the potential to hedge against inflation and fiat currency debasement.
Stay Diversified and Prepared
In our view, it is vital to assess which investments may have the potential to mitigate against and deliver positive exposure to higher inflation. At the same time, we believe inflation exposure should be seen as an important way to diversify, as many investors may lack significant inflation exposure after experiencing a long period of stable prices.
We would warn against moving too much toward inflation-benefitting assets, while reinforcing the idea that the mix of inflation-sensitive assets will likely affect results. Some, such as commodities, are volatile but have fairly low correlations with equities and bonds. Others, such as value stocks or listed real estate, are more correlated. Floating-rate loans typically carry moderate volatility and correlation with equities and bonds, but may be vulnerable to credit risk. And TIPS have traditionally helped to mitigate against inflation, but are richly valued.
Creating the right mix of inflation-related and traditional assets may warrant careful thought and execution. But we believe it can help investors more effectively navigate the changing environment ahead.
Portfolio Ideas for an Inflationary Environment
Minimize Interest Rate Risk
Short-duration bonds, non-investment grade fixed income, municipal bonds, value equity, equity income
Inflation-linked earnings and income
Commodities, real estate, commodity equities, REITs, MLPs, cyclical stocks, luxury goods and leisure stocks, emerging markets, index-linked bonds, loans, private credit
Flexible, nimble active strategies
Gold, digital assets, market-neutral strategies, macro strategies, equity index put-writing, quality equity, flexible credit strategies, private marketst
Source: Neuberger Berman. For illustrative purposes only. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investing entails risks, including possible loss of principal.
This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor’s individual objectives and circumstances and in consultation with his or her advisors. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. The firm, its employees and advisory clients may hold positions within sectors discussed, including any companies specifically identified. Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. Neuberger Berman, as well as its employees, does not provide tax or legal advice. You should consult your accountant, tax adviser and/or attorney for advice concerning your particular circumstances. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Any discussion of environmental, social and governance (ESG) factor and ratings are for informational purposes only and should not be relied upon as a basis for making an investment decision. ESG factors are one of many factors that may be considered when making investment decisions. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. The use of tools cannot guarantee performance. Diversification does not guarantee profit or protect against loss in declining markets. As with any investment, there is the possibility of profit as well as the risk of loss. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
The views expressed herein may include those of the Neuberger Berman Multi-Asset Class (MAC) team, Neuberger Berman’s Asset Allocation Committee and Neuberger Berman’s Investment Strategy Group (ISG). The Asset Allocation Committee is comprised of professionals across multiple disciplines, including equity and fixed income strategists and portfolio managers. The Asset Allocation Committee reviews and sets long-term asset allocation models, establishes preferred near-term tactical asset class allocations and, upon request, reviews asset allocations for large diversified mandates. Tactical asset allocation views are based on a hypothetical reference portfolio. ISG analyzes market and economic indicators to develop asset allocation strategies. ISG consists of five investment professionals and works in partnership with the Office of the CIO. ISG also consults regularly with portfolio managers and investment officers across the firm. The views of the MAC team, the Asset Allocation Committee and ISG may not reflect the views of the firm as a whole, and Neuberger Berman advisers and portfolio managers may take contrary positions to the views of the MAC team, the Asset Allocation Committee and ISG. The MAC team, the Asset Allocation Committee and ISG views do not constitute a prediction or projection of future events or future market behavior. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. The duration and characteristics of past market/economic cycles and market behavior, including length and recovery time of past recessions and market downturns, is no indication of the duration and characteristics of any current or future market/economic cycles or behavior.
A bond’s value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. Neither Neuberger Berman, nor its employees provide tax or legal advice. You should consult your accountant, tax adviser and/or attorney for advice concerning your particular circumstances. This information should not be construed as specific tax or investment advice. Please contact a tax advisor regarding the suitability of tax-exempt investments in your portfolio. If sold prior to maturity, municipal securities are subject to gains/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes based on the investor’s state of residence.
For more information on COVID-19, please refer to the Centers for Disease Control and Prevention at cdc.gov.
Neuberger Berman Investment Advisers LLC is a registered investment adviser. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.