With the threat of rising inflation in recent weeks – or perhaps more accurately, a lot of talk about rising inflation – it is recommended that investors allocate more to equities, gold, and real assets as a means of hedging inflationary risk.

Inflation fears come in the wake of the massive fiscal and monetary stimulus programmes in the United States, Japan, and Europe, which are pumping liquidity into the financial markets. In the US, 10-year US Treasury yield and mortgage rates are already climbing in anticipation of the US Federal Reserve raising interest rates and triggering a sharp rise in prices. Some analysts believe that while short-term fears are not warranted, there is cause for long-term concern.

“Part of me thinks that the pervasive narrative by the talking heads on TV and the blogger ‘influencers’ has been inflation. Inflation. Inflation. Inflation. We’ve had a massive run-up in commodities, and this certainly helps to underpin the inflation thesis. But how much of this run-up is speculative versus real demand?” asks Jack Janasiewicz, senior vice president, portfolio strategist and portfolio manager at Natixis.

Although there is no consensus among asset managers as to how serious the inflationary risk actually is, investors are being warned to at least expect inflation to hit moderate levels and position their portfolios accordingly.

“When inflation rises from the average, as in a reflationary environment like we’re expecting, risk assets perform well, with US equities, oil, energy stocks, and real estate outperforming. Broadly, portfolios should reallocate from bonds to equities and commodities,” says Alex Wolf, head of investment strategy, Asia, at J.P. Morgan Private Bank.

Two scenarios

J.P. Morgan PB is looking at two scenarios: inflation rising slightly above the average (“average” is defined as one standard deviation above the mean) and inflation rising substantially above the average (rising to two standard deviations from the mean).

In both scenarios, gold tends to do well because rising inflation produces deeply negative real rates, which boost gold. “However, in this environment, we are looking at deeply negative real interest rates, and going forward we expect real rates to rise and nominal yields to pick up. Nonetheless, as a hedge against higher inflation, gold also makes sense,” Wolf says.

Wolf, however, adds a caveat that inflation is a process rather than an event, and when inflation moves from a benign reflationary environment to one where it begins to rise substantially, whether due to supply shocks (labour or commodities) or substantial stimulus-driven demand, real assets (such as real estate, commodities and energy equities) significantly outperform financial assets (bonds, credit and equities).

According to Standard Chartered Bank’s latest Wealth Management Outlook, recent data have reignited inflation worries, but the rise in inflation is expected to be short-lived given still-wide gaps to full employment in major economies.

Based on these findings Standard Chartered maintains its preference for global equities as well as emerging-market and high-yield corporate bonds, noting they have historically performed well in both rising and falling inflation scenarios as long as global growth is rising.

Attractive hedge

“We raise euro area equities to preferred, alongside the UK and the US, as the region’s Covid-19 vaccinations accelerate and earnings expectations surge. Gold offers an attractive hedge against an upside inflation surprise, even as prices are supported near-term by transitory inflation. A growth catch-up outside the US could push US relative yields lower, supporting our bearish US dollar view,” according to the report.

For Asia, surging soft commodity prices are of particular concern, given their greater impact on inflation, according to Deutsche Bank’s Asia Macro Insight. The bank has revised its inflation forecast upwards in the face of sharply higher commodity prices.

It also notes the deteriorating growth outlook because of weaker-than-expected GDP growth in the first quarter as a result of recurring Covid-19 outbreaks that have temporarily limited rebound in domestic demand. Surging exports should, however, mitigate the impact of weak consumption on overall economic activity.