Multi asset: navigating an inflation shock

Successful investing requires dedicated attention (and continual adaptation) to economic regimes, given their dominant influence across markets. The current situation in Iran is a clear example, having triggered an inflation shock. Such scenarios can be challenging for investors, as they can undermine asset values, may be costly to hedge and nearly impossible to time accurately. Our Q2 issue of Simply put explores the impact of inflation shocks and considers ways to respond effectively.  

The CIO’s perspective: this is inflation (again)

In our view, three macroeconomic regimes are central to any investment strategy – and form the foundation of our All Roads strategic risk-diversification principles:

1.	periods of improving growth
2.	periods of deteriorating growth
3.	periods of (unexpected) inflation.

Our analysis of these regimes from 1968 to 2026 reveals a clear pattern we call the 40 40 20 rule (see Figure 1): growth regimes (positive and negative) each occur about 40% of the time, while inflation regimes appear only around 20% of the time. Their rarity makes them less persistent and harder to time, which is why traditional cross-asset portfolios often lack dedicated exposure to inflation-sensitive assets, instruments or strategies.

FIG 1. Historical frequencies of world macro regimes from 1968 to 2026²

  
Not all inflation shocks are the same. Inflation typically stems from either a temporary surge in demand or from supply disruptions. While most shocks last more than six months, supply-driven inflation more frequently evolves into demand-driven inflation than the reverse – consumers adapt more slowly to supply constraints than producers adapt to rising demand.

Read more: Finding signals in the noise of the Iran oil shock

Crucially, inflation erodes excess performance across most asset classes, except cash and commodities, meaning traditional diversification often breaks down when inflation rises. This calls for caution, i.e., diversifying the diversifiers. In the All Roads strategy, we use a broad mix of assets with potential inflation sensitivity, complemented by dynamic overlays that adjust as conditions change. A broader toolbox has long supported our investment process, and we expect it to remain essential.

Portfolio positioning: what the current shock means 

Inflation shocks create unusually complex conditions for investors. Inflation doesn’t inherently weaken equities, but it does directly pressure bonds, undermining a core source of diversification. Inflation can also benefit commodities, an asset class underrepresented in most portfolios.

In Q1, our risk metrics showed a sharp reversal of the long-running normalisation in volatility, driven by rising geopolitical uncertainty. This underscores one of the most challenging features of an inflation shock: it lifts risk across all markets. Our trend signals also indicated mounting inflation pressures weighing on bonds, while momentum declined across most asset classes (commodities were the exception). Risk appetite fell as well, though not enough to suggest broad-based stress.

From a macro perspective, this shock is exogenous, so its effects will hit the real economy before macro data fully reflects them. The Iran war introduces two layers of uncertainty: how long and intense the conflict will be, and how large its eventual impact on the global economy becomes. For now, our nowcasters remain near neutral, but we expect clearer signals on growth, inflation and monetary policy to emerge over the coming quarter.

Our diversification framework blends growth assets, bonds and investments that naturally respond during inflationary periods. Inflation swaps, commodities and rate-volatility strategies help protect against supply-driven inflation shocks. Last quarter marked Act I of the current episode and the activation of our first line of defence. As the situation evolves, our continual adaptation process is leading us to reinforce our defensive stance while maintaining meaningful market exposure, given the unusually high uncertainty surrounding the path ahead.

Read more: Iran oil shock: how could the US, Europe and Asia be impacted?

Macro: inflation persistence

The Strait of Hormuz blockade triggered an oil shock, pushing global inflation higher. But how long could this inflation shock last? Demand-driven shocks tend to leave more persistent marks on core inflation through wages and expectations. Supply-driven shocks can be just as enduring when they are broad-based, repeated or spread through production networks. Supply chain disruptions can exhibit more persistence than traditional oil shocks, particularly when they affect upstream production inputs. 

Ultimately, inflation persistence reflects a combination of the shock’s origin, the monetary policy response and how well expectations remain anchored. This helps explain why similar supply shocks can produce either brief inflation spikes or sustained price pressures.

A useful comparison is the 1990–1991 Gulf War, which shares many similarities with today’s disruptions to oil production and shipping. As Figure 2 shows, energy inflation remained elevated even after oil prices normalised, and core inflation continued to rise for six months after the oil price peak.

The lesson is that energy-driven inflation shocks can remain persistent long after the initial trigger fades. Given the uncertainty surrounding both the evolving situation in Iran and the durability of this inflation impulse, maintaining inflation hedges in global portfolios is essential.

FIG 2. Case study of the inflation consequences of the Gulf War³

 

Read more: Oil prices and the Middle East conflict: the economic shock investors should watch

Special focus: investing in times of inflation

Inflation can leave deep marks on even well-diversified portfolios. Each inflation episode raises the same questions: do effective inflation-hedging tools exist, and can they be used without excessive cost?

Cash, commodities and volatility strategies are attractive hedges, often delivering strong performance during demand-driven inflation shocks. But because inflation shocks are typically brief, they’re hard to time – prompting the question of whether hedging something so short-lived is worthwhile.

In our view, hedging inflation risk is essential in a diversified portfolio, but effective hedging requires careful consideration of the right solution for each specific type of shock. Commodity exposures, rates-volatility and equity-volatility strategies all offer robust protection across both demand- and supply-driven inflation shocks – and their benefits often last beyond the shock itself, which matters given how short inflation episodes tend to be.

Our All Roads franchise recognises the importance of managing inflation risk and deploys a range of solutions, including commodities, inflation swaps, rates and equity volatility, and eventually dynamic drawdown management that shifts into cash when needed to mitigate the market and macroeconomic fallout of inflation periods.

New research: Building an inflation-resilient strategic asset allocation 

Strategic asset allocation depends on long-term return estimates, which often overlook specific market regimes and rely on tactical adjustments to respond to current conditions. But ignoring inflation regimes can be costly when inflation risk rises suddenly. We believe strategic asset allocations can be built to remain resilient to inflation without over-relying on hedging assets.

The portfolio construction of our All Roads strategies factors in macro regimes as an anchor to its long-term diversification.  This approach is akin to Regime Parity – an investment approach that aims to build optimal asset mixes for different economic regimes and then blend these various portfolios based on the likelihood of each regime occurring.

Adapting a strategic asset allocation to account for inflation is relatively straightforward. Our methodology follows four steps for designing an inflation-resilient Regime Parity portfolio:

1.	defining and dating regimes
2.	estimating the regime-specific covariance matrix
3.	estimating the regime-specific portfolio
4.	defining the regime probabilities.

Simply put, ignoring regime-specific information when building a strategic asset allocation can prove detrimental when such regimes occur. The current inflationary shock highlights the importance of inflation hedges in risk-based portfolios and the effectiveness of a Regime Parity strategy.