As the economic recovery gains traction, inflationary pressures are building and markets are responding. The unprecedented nature of the COVID-19 cycle is leading investors to ask: is inflation here to stay?

In our latest insights piece, we explore this question, providing scenarios for inflation and what each would means for asset allocation. What follows is a summary of this perspective.

 

Our view on inflation

In the U.S., recovery from the COVID-19 pandemic is well underway as vaccinations continue and health-related restrictions ease. Aggregate demand has strengthened, aided by monetary policy’s favorable impact on financial conditions and fiscal policy’s support of household and business balance sheets. At the same time, supply is constrained, both in terms of restarting production after large-scale shutdowns, as well as in labor terms due to ongoing virus safety and childcare constraints—and, in some cases, the extension of federal unemployment insurance benefits.

Prices have already responded to these supply-demand imbalances—inflation figures have surprised to the upside in recent months—but evidence does not yet point to inflationary pressures beyond temporary supply-demand imbalances. Instead, we expect that growth and consumption will revert to more typical patterns once the reopening surge passes, while on the supply chain, production picks up, bottlenecks are cleared and labor force participation climbs. 

 

Supply-demand imbalances mean costs are rising, but expectations for future increases are more modest

U.S. economic and market inflation data

Sources: New York Life Investments Multi-Asset Solutions, U.S. Bureau of Labor Statistics, Bloomberg LP, 7/18/21. Past performance is no guarantee of future results. An investment cannot be made in an index.

 

In addition, our estimation of structural factors suggests that the underlying inflation trend will firm only modestly as the recovery continues. To reverse these disinflationary forces, large-scale policy commitments—and durable ones—would likely be required. For more context surrounding these factors, please see page 5 of our latest insights piece, referenced earlier.

 

What could be different? Scenarios for post-crisis inflation

Having reflected on our base case views, we must also admit that the inflation outlook includes a considerable amount of uncertainty. This stems from a confluence of factors: an economy and labor force that are likely to have been reshaped by the pandemic in ways that are still not fully understood; a central bank that is willing to accept higher inflation in exchange for a strong labor market; and expansionary fiscal policy that will also reallocate resources towards lower- and middle-income households.

As such, we will be closely monitoring the path of inflation moving forward. The table below summarizes what we believe to be the key scenarios for inflation.

 

Scenarios for post-pandemic inflation
These scenarios reflect inflation targets for the 2-3 year period starting mid-2022, after consensus expects supply-demand imbalances to have faded. 

Source: Views of the Multi-Asset Solutions team, 6/30/21. Author’s note: Given the accommodative monetary policy setting, a strong growth outlook and the relatively short time horizon for our scenarios, we set aside a recession scenario in our analysis. Including a recession scenario would increase the weight we assign to the “return to lowflation” scenario.

 

Investing through inflation uncertainty

In the end, inflation does not occur in a vacuum, particularly with respect to its implications for investing. Is inflation accompanied by strong growth? Are price pressures lasting or only temporary? Will they be accompanied by higher rates or a steepening curve? Will policy react? All of these questions – coupled with the goals and risk tolerance of the investor – will impact an investor’s approach.

Given these complicated considerations, there are several levers that seasoned managers can pull in order to make the appropriate investment decisions for clients in an inflationary environment.

Asset allocation. The ability to anticipate a change in inflation regime—before market pricing fully reflects that change—can add meaningful portfolio alpha potential[1]. Asset allocators must consider not only the inflationary environment, but the likely durability of that environment. This assessment will drive important changes in either tactical or structural allocation.

Security selection. Skilled managers can assess company business models for characteristics that would thrive in an inflationary scenario or persist in a disinflationary one. As the macroeconomic environment changes, and as market breadth expands and narrows, it is particularly important to identify company characteristics, such as: pricing power, credit evaluation, and business model drivers.

Sources of return. Asset prices are not the only sources of investor return, which can impact the tradeoff between assets as conditions change.

Client focus. For some investors, inflation protection is essential. The best multi-asset allocation will be that which aligns sources of return with investor goals. 

1. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.

All investments are subject to risk including loss of principal.

The opinions expressed are those of the Multi-Asset Solutions team, an investment team within New York Life Investment Management LLC and not necessarily those of other investment boutiques affiliated with New York Life Investments.

Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal, or volatility of returns. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors, and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company.

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