The debate over whether recent inflationary pressures are structural or cyclical has given rise to different ‘camps’ in the investment community. The structural camp believes that low inflation in recent decades was an accident of history, and that covid, geopolitics and energy transitions have structurally changed the inflation dynamic. They argue investors need to realign portfolios to a new reality of repeat inflation shocks. The cyclical camp believes that central bankers can still get inflation under control. This disagreement has implications for future correlation between stock and bond returns.
Structural camp sees end of tailwinds that suppressed prices
The structural camp argues that calm energy markets, globalization and Chinese demographics provided tailwinds that reduced goods prices by lowering labor costs. But covid supply shocks, Russian aggression upending globalization, China’s working age population peaking, and challenges transitioning to renewables have removed those tailwinds. This makes repeat inflation spikes more likely as central banks play ‘whack-a-mole’.
Recurrent inflation would increase portfolio volatility
If inflation becomes more recurrent, it may positively correlate stock and bond returns instead of them being negatively correlated. This would significantly increase the volatility of balanced portfolios like 60/40. So investors are rethinking asset allocation strategies.
Cryptocurrencies have tracked stocks, reducing diversification value
Cryptocurrencies were hoped to provide an inflation hedge, but have moved in lockstep with stocks over the past year. Illiquid alternatives like private equity haven’t provided much extra diversification either during this period of volatility. Some better options may be long-short equity strategies, or allocating to commodity futures.
Debate rages whether inflation shocks are structural or cyclical. The structural camp believes tailwinds suppressing prices have permanently abated. This may positively correlate stock and bond returns, increasing portfolio volatility. New diversifiers like crypto have disappointed, leading investors to explore long-short equities or commodities.