With more than two decades of stable inflation in the US and forecasts calling for moderate inflation in the short term, many investors have become complacent about the risk of inflation to the real value of their portfolios. But inflation can change unexpectedly, and although we don’t believe that change is necessarily imminent, investors should remain vigilant about addressing this risk.
Unconcern is concerning
For long-term investors, managing inflation risk is about protecting their purchasing power while preserving capital. Pre-retirees and retirees are especially vulnerable to the corrosive impact of inflation, which can substantially reduce their standard of living in retirement if their portfolios fail to keep pace with the inflation rate. Adding to these concerns, inflation disproportionally affects spending categories retirees are most sensitive to, including transportation, food and especially medical care.
All investors, however, confront the risk that their portfolios could underperform inflation. Unexpected inflation, in particular, can materially impact returns, yet investors remain generally unconcerned.
Investors have been lulled into complacency by the fact that recent aggressive quantitative easing programs have resulted in an unprecedented level of liquidity in the system, but inflation remains muted, with current inflation levels remaining near historical lows.
The case for inflation protection
In our view, these considerations are critical for investors to effectively manage inflation risk:
- When, not if. Our review of US economic history and the current economic outlook suggests that while it doesn’t appear imminent, higher inflation is inevitable.
- The cost of timing the market. In any environment, but more so in this one, determining the exact timing and scope of a rise in inflation is difficult. Because unexpected inflation has tended to surprise on the upside, adding inflation protection after the fact could be costly.
- Ever-present risk. While most concerns about inflation are focused on the risk of an unanticipated sharp rise in inflation, even slightly above-average inflation can significantly erode wealth over time. Inflation should therefore be viewed as a long-term challenge that can hurt portfolios whether inflation is high or simply above average.
The bottom line is that investors should always be prepared for the impact of different inflation outcomes. We believe the most appropriate approach to addressing this challenge involves a multi-asset strategy that seeks to deeply embed inflation mitigation in the portfolio construction process.
Why a multi-asset approach to inflation
Our multi-asset approach begins with an assessment of the historical performance of asset classes and their effectiveness in outperforming inflation. We apply our analytical framework — which defines four distinct macroeconomic regimes in terms of inflation and economic growth outcomes — to more than 40 years of data to determine how different asset classes performed in the different regimes.
While no single asset class performs the same in all environments, our research indicates that at least a few asset classes in each environment may help protect the real value of assets. For example, during periods of high inflation and economic growth, investments that performed well included commodities and real estate investment trusts (REITs). Likewise, Treasury inflation-protected securities (TIPS) and sector-specific equities, such as utilities, energy and health care, performed well during economic contractions.
Inflation and economic growth drive asset class outperformance in different macroeconomic environments. By incorporating expectations for changes in these drivers into asset allocation decisions, a multi-asset approach can:
- Help mitigate risk created by the impact of shifting economic environments on asset prices.
- Offer flexibility to allocate investments across a wide spectrum of asset classes that have the greatest potential to outperform inflation.
Learn more about Invesco Multi-Asset Inflation Fund.
The real value of assets is the value of assets adjusted for inflation.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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