Positioning the portfolio in the face of potentially persistent and possible inflation. T. Rowe Price explains that, for over a decade, inflation has not been considered a major investment risk: since the global financial crisis onwards, in fact, deflation has changed the perception of it. As inflationary pressures are mounting around the world, the scenario may change again, although it is widely believed that the upturn is temporary.
Persistently high inflation levels could be a problem for financial markets, according to the investment firm. In general, high inflation leads to higher interest rates, which can lead to a sell-off in bond markets. Under these conditions, the greater correlation between stocks and bonds can reduce the benefits of diversifying a multi-asset portfolio.
For T. Rowe Price, short-term inflation in the United States will be higher than in the past decade, but not enough to be a major concern. Recent inflation data has been heavily influenced by the extreme rise in prices in sectors that have seen an abrupt halt and subsequent recovery due to the pandemic,
Looking in detail at the drivers of rising inflation, the US firm believes that these should ease in the near term. A key driver on the demand side, for example, has been the reopening of major economies following pandemic restrictions, but, being unlikely to happen again, T. Rowe Price believes the current spending momentum will subside over time.
A second driver has been the disruption in the production chains, but with the return to normal (or a sort of normalcy), supply and production should return to pre-pandemic levels. Finally, a third factor was the base effect, since inflation is generally measured on an annual basis, i.e. today’s prices are compared to last year’s. Given that economies around the world have been slowed down by the pandemic, causing demand and prices to plummet, it is not surprising the large percentage change given the low starting base.
While the evidence indicates that the inflation spike is temporary, not only cannot it be certain, but a long period of price growth cannot be ruled out either. As a result, the investment firm is closely monitoring housing costs, a significant component of consumer prices, as well as wage inflation, as persistent increases in these two components could fuel inflation. In addition, logistical and supply slowdowns may persist and some sectors may be slower than others to return to full capacity.
In light of all this, T. Rowe Price believes that portfolios must include some protection, in balance with its cost, and to achieve it he points out three investment ideas. A first way could be the purchase of inflation-linked (ILB) sovereign bonds, designed to help investors protect their portfolios from inflation by being indexed to the price level, so that principal payments and interest follow suit. trend of inflation. However, in many markets ILBs have a significant cost, which means that they offer low or negative returns after inflation, leading to a risk of negative total returns in real terms. Another aspect to consider is that ILBs outperform standard nominal government bonds with similar duration only if the effective inflation is higher than the breakeven inflation rate (reflected in the difference between the yield on nominal bonds and ILBs). The fact that breakeven rates are currently quite high makes it difficult for ILBs to outperform.
A second way is to invest in cyclical stocks, which tend to perform well in a context of rising prices; these include value stocks, small cap stocks, and Japanese, European and emerging market stocks. Inflation typically rises during periods of economic expansion, when cyclical assets are doing well. Finally, a third way is to purchase high yield assets with a relatively short duration, such as global high yield bonds and emerging market debt. The higher returns represent a buffer to add to total revenues, compared to redeeming traditional coupons. The two main risks are related to the fact that both assets are linked to the equity markets, and therefore do not diversify the risk,
The advantage of the investment ideas in points 2 and 3, according to T. Rowe Price, is that they should perform well during periods of both high and low inflation. In essence, they could provide inflation protection without the cost of reducing expected revenues. As it is not possible to be certain about the level of inflation in the coming years, the investment strategies indicated could prove particularly useful. (All rights reserved)

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