Home / Asset Allocation / From Goldilocks to gold: Mercer sets scenes for inflation

From Goldilocks to gold: Mercer sets scenes for inflation

Asset Allocation

Mercer has urged investors to consider a wider range of inflation scenarios in portfolio design plans as price uncertainty ramps up across the world.

In a new paper, the global multi-manager and consultancy firm says investors now face more complicated decisions amid confusing inflation signals.

“Adding a less predictable inflation environment now increases complexity for portfolio construction, as the asset allocator needs to think about inflation sensitivity (“inflation beta”), not just growth sensitivity (“GDP beta”),” the Mercer study says. “Although some portfolios will employ inflation protection through investing in Treasury Inflation-Protected Securities (TIPS) or index-linked gilts, which also come with limitations, few portfolios appear comprehensively hedged against inflation risks.”

  • Despite leaning to the more optimistic side of the argument, Mercer makes the case for a structural shift to higher inflation ahead as demographic and labour supply pressures tilt the scales away from the price-constrained trends of the previous four decades.

    “What fuels our concerns over higher inflation risk and wider tail outcomes is not so much this short-term spike in inflation seen in 2021 as it is the weakening of long-term secular, disinflationary forces in the background,” the paper says.

    Mercer lays out six potential inflation scenarios ranging from the ‘Goldilocks’ outcome – where strong growth and productivity gains conspire to keep prices down – to the worst-case ‘pandemic stagflation’ caused by resurgent COVID, slow growth and supply-chain-led price increases.

    Each scenario would have materially different effects on various asset classes. Under the Goldilocks outcome, for instance, almost all assets rise while only commodities and gold offer much hope of return if stagflation arrives.

    The report says Mercer currently favours the ‘balanced growth’ scenario – moderate growth and inflation – but investors should not discount other possibilities.

    “For the first time in a generation, investors need to seriously consider inflation,” the paper says. “… The range of scenarios for inflation in the future has increased, and scenario analysis can provide insight into the risks to portfolios.”

    And investors will have to consider a wide set of asset classes to provide portfolio inflation-protection, Mercer says.

    “Even inflation-linked bonds, which may appear as the most intuitive solution given their contractual link to inflation, do not perform well in any of the short-term scenarios. This is because, in the near term, they are more exposed to changes in real rates than to changes in inflation expectations,” the report says. “Over the longer term, the inflation linkage strengthens, but in many markets, investors are locking in negative real rates by investing in inflation-linked bonds. We see inflation-linked bonds as part of the toolkit, but more tools are needed.”

    Investors assessing current portfolio inflation risks should weigh up several factors, Mercer says, including:

    • holdings of existing inflation-sensitive assets;
    • the time horizon over which inflation-linked assets are expected to provide protection;
    • identifying what scenario would leave the portfolio most vulnerable;
    • the types of desired inflation-protection – such as general consumer price index or more targeted metrics (healthcare, for example);
    • liquidity budgets;
    • governance rules; and,
    • environmental, social and governance (ESG) considerations.

    The study highlights a potential conflict between inflation-protection strategies and ESG targets with higher commodities exposures, for instance, butting against portfolio decarbonisation targets.

    Coining a new acronym for the already crowded ESG dictionary of jargon, Mercer says: “Investors also need to balance positioning portfolios for higher inflation risk in the medium term while maintaining their long-term focus on decarbonizing portfolios — we refer to decarbonization-at-the-right-price (DARP).”

    For history buffs, too, the report lays out a time-line dating back to 1209 that shows inflation regimes have moved in long cycles in the past.

    While investors might choose to ignore historical trends (and, there is “indeed merit in not extrapolating naively”), Mercer says the longer view adds valuable perspective.

    “Just because we have been fortunate enough to live through a multi-decade disinflationary cycle until now does not mean we have reached the end of history,” the paper says.




    Print Article

    Related
    From Covid to conflict, the issues set to drive markets

    From Covid to conflict, all it took was just a few weeks for the market to shift its attention to the unfolding crisis in Ukraine and away from the pandemic. The crisis disrupted supply chains and triggered record-high inflation which forced central bankers to raise rates to contain the rise. What came next, was a…

    Ishan Dan | 19th May 2022 | More
    Super wars renewed by Morrison ahead of election

    Once a stalking horse for a small cabal of noisy backbenchers, “Home First, Super Second” has found its way into the Coalition’s policy arsenal ahead of an unpredictable election. It was perhaps premature to write, in late March, that the super wars were over. Scott Morrison’s announcement on Sunday that first home buyers would be able…

    Lachlan Maddock | 19th May 2022 | More
    Good time to buy quality semiconductor companies, say experts

    For investors looking to build positions in quality technology firms, the US computer chip giants are trading at attractive price levels, with many brokers now rating them as a buy, according to data from the Wall Street Journal. The prices of semiconductor companies have dropped sharply this year amidst a broader sell-off in technology stocks…

    Nicki Bourlioufas | 19th May 2022 | More
    Popular
    1
    What does High Conviction mean?
    Ishan Dan | 18th Mar 2021 | More
    2
    Evergreen ratings highlights new venture capital prospect
    Ishan Dan | 18th Nov 2021 | More
    3
    FASEA exam extended nine months*, waiting period waived
    The Inside Adviser | 12th Jul 2021 | More
    4
    Top hedge fund award goes to L1 Capital
    Greg Bright | 13th Dec 2021 | More
    5
    Better Advice Bill changes enter consultation
    Staff Writer | 30th Sep 2021 | More
    6
    IN60 with Andre Roberts from Invesco
    The Inside Adviser | 18th Oct 2021 | More