For macro and market observers, inflation has gone from being the primary concern in 2021-2023 to a secondary factor today. This change is attributable to disinflation, as illustrated by European inflation falling below 2% and the rate-cutting actions of most major central banks (with the exception of Japan’s). Among investors, the consensus now is that inflation is set to recede and that maintaining hedges is not a priority.
As our readers may know, we adhere to the ‘40-40-20’ mantra: 40% of economic history is characterised by improving growth conditions, another 40% by periods of deteriorating growth and the remaining 20% by unexpected increases in inflation. Regarding the latter, it is important to remember that the behaviour of risk premia is not driven by the actual level of inflation but the change in investors’ expectations: in other words, inflation surprises. With receding inflation the consensus view, this has contributed to inflation-linked assets being currently undervalued, according to our measures, despite the fact that inflationary periods have accounted for less than 20% of the past few decades.
Should we also reduce inflation-sensitive exposures in our multi-asset strategy? The answer is not straightforward. Here we provide our take, in Simply put mode.
What inflation?
After reaching 8.8% in 2021 and 6.0% in 2022, the recent dip in US inflation below 3% has seemingly convinced markets and economists that the Federal Reserve (Fed) has finally tamed the post-Covid inflation surge. According to private-sector economists’ forecasts for 2025 and 2026, US inflation is expected to fall below 3% to 2.2% and 2.3% respectively. In the eurozone, the latest inflation reading of 1.8% is lower than the European Central Bank’s (ECB's) target of 2%, but the general expectation is that it will stabilise at this level over the next two years.
These unified forecasts have similarly influenced investor consensus. Figure 1 illustrates the recent ranking of various asset classes based on their performance trend and carry. Inflation-linked assets (inflation-linked bonds and commodities) are performing poorly in terms of trends but are considered the best in terms of carry. Consequently, they are currently viewed as ‘cheap’ across a broad spectrum of markets given the lack of investor appetite for them. This stands in stark contrast to other market segments, like US large caps, which are deemed expensive. But the question remains: is inflation truly a past concern?
FIG 1. Asset-class rankings based on the trend and carry1
To subscribe to investment insights and strategy updates, click here. Inflation’s smile
To address that question, we could consider the structural trends likely to influence inflation over the next decade. These include the greying population and shrinking working-age cohort, economic regionalisation and climate-related spending. This approach may suit long-term analyses but will probably not be particularly useful for anticipating the level of inflation in the next quarter. Instead, examining the recent evolution of our extended set of inflation nowcasters offers a more immediate perspective on the likely path of inflation risks.
We explore this in Figure 2. The chart shows nowcaster elements that aggregate a considerable amount of local data that have been historically proven to provide a reliable gauge of each country's inflation risk. Focusing on the G10 nations and China, the charts illustrates different averages of these metrics to demonstrate the effect of inflationary trends. These averages are: the period since 2021 (encompassing most of the inflation shock), the past 12 and three-month averages, and the most recent values.
Together, they ‘smile’ at us. The longer-term averages indicate the straightforward phase of disinflation is apparently over, giving rise to a more recent uptick in inflationary pressures. There is some gap between the most recent reading for New Zealand and Switzerland, where inflation seems weakest and strongest respectively, but national differences are less significant than the overall trend. It shows an increasing number of these indicators are now on the rise, challenging the macro and market consensus that inflation is receding.
Figure 2: Recent evolution by country of LOIM inflation Nowcasters2
What this means for All Roads
From a portfolio construction perspective, our 40-40-20 mantra remains central to our structural risk-allocation strategy. This approach dictates that 20% of our focus should be on regimes characterised by positive inflation surprises, guiding our allocation towards clear inflation hedges, such as commodities and inflation swaps. Given their bearish trends, we are not invested heavily in these assets, but maintained exposure for two reasons: inflation can be unpredictable, and we believe the current risk-reward ratio for these assets is attractive.
Simply put, inflation-linked assets currently show an appealing risk-return profile and are instrumental in prudent risk management.
To learn more about our All Roads multi-asset strategy, click here. Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth data continue to improve, with currently, 68% of the data we collect in the US shows signs of strength
- Inflation pressures are still on an uptrend, with an average of 53% of the data indicating progression
- Monetary policy remains dovish but 60% of the data are trending higher, indicating the potential for a surprise.
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
