As inflation recedes from recent cyclical highs, many investors are selling their holdings of inflation-protected securities. The result? Explicit inflation protection has become unusually cheap. Investors needing to boost their strategic allocations to inflation strategies may wish to take advantage of this opportunity—securing inexpensive “flood” insurance ahead of higher structural inflation over the coming decade.
Entering a Regime of Higher—and Spikier—Inflation
For the past 40 years, global deflationary forces have prevailed, facilitating a regime of low equilibrium inflation. But mounting pressures from macro megaforces point toward higher structural inflation and increased vulnerability to inflation shocks in the years ahead. At the core of our expectations are three powerful forces: deglobalization, aging demographics and climate change.
- Deglobalization leads to higher inflation by constraining the global pool of labor and increasing labor’s bargaining power, among other factors.
- Meanwhile, the global labor pool is shrinking, thanks to aging demographics. Without a sustained increase in productivity to offset it, a shrinking workforce empowers labor—yet another inflationary factor.
- The inflationary effects of deglobalization and demographics could be compounded by climate change. For instance, the energy transition—while probably deflationary in the long term—could drive costs higher in the next decade.
As a result, we think it’s more likely that 2% becomes a lower bound for inflation, rather than a central-bank target. Indeed, it’s highly likely we’ve already entered this new regime, though evidence of it has been masked by recent disinflation from cyclical highs. That said, frequent surges in inflation may themselves be characteristic of the new regime.
As we’ve all recently been reminded, surges in inflation hurt. In the last three years alone, US consumers cumulatively lost 16% in purchasing power. It’s no wonder consumer sentiment bottomed in 2022. Yet even marginally higher inflation represents a key risk. For example, if inflation persists at just 2.8%, an unprotected investor will have lost 35% of purchasing power 15 years from today and be farther than expected from meeting investment objectives.
The Case for a Strategic Allocation to Protection
Inflation is hard to predict. Many investors—and even central bankers—have underestimated the frequency and magnitude of inflation. When we compared market inflation expectations1 to realized inflation over the last 18 years, realized inflation came in above expectations more than 80% of the time (Display). On average, the market underestimated inflation by 1.41%, while overestimating by just 0.66%, putting the odds in favor of a strategic allocation to inflation protection.