Historically, inflation has gone through regimes.

Inflation tends to move in regimes over long periods. For example, from the post-Volker era until 2020, the global economy experienced a period of low inflation, with various positive supply-side shocks. This included globalization (China exporting deflation), the formation of the EU single market, declines in global tariffs, technological developments improving productivity, de-unionization of labor forces, and de-regulation.

Relatively benign inflation hasn’t always been the case. During the 1970s, for example, we saw a regime of high and volatile inflation. This was driven by loose monetary policy (collapse of Bretton Woods) and a series of supply-side shocks, such as in the oil market.

Higher inflation volatility likely to stay

We believe we’re entering a regime of higher inflation volatility. This should cause more frequent changes to central bank policy (bond volatility). The driver of this view is the increased chance of negative supply-side shocks.

Rising geopolitical tensions (competition between the US and China) lead to a retracement in globalization (tariffs, regulations, onshoring supply chains, commodity hoarding, etc.) (Chart 1).

Chart 1. Rising geopolitical uncertainty

The impact of climate change, whether by government policy (energy transition, etc.) or more extreme weather events (El Niño, water levels, etc.).

Changes in government policy, such as a rise in government debt and less fiscal conservatism. Since the pandemic, we have seen a material increase in government debt and few signs of fiscal restraint despite a very strong economic and employment environment over the last couple of years. In the US, for example, the fiscal deficit is expected to average greater than 6% of gross domestic product over 2023–24, despite an unemployment rate that is forecast to average less than 4% (Chart 2).

Chart 2. Little fiscal restraint in the US, despite a strong economy/labor market

A new challenge for central banks

Negative supply-side shocks are more difficult for central banks to navigate than demand-side shocks. This is because they affect growth (down) and inflation (up) differently, meaning central banks must prioritize stabilizing inflation or growth.

Various central banks are likely to approach this differently, and given the high level of government debt globally, there’s considerable political pressure on central banks to keep bond yields low (government debt costs).

What does this mean for diversification?

Because demand shocks push growth and inflation in the same direction, they tend to propel bond and equity prices in different directions (negative correlation). So, when growth is strong, equity prices tend to rise while bond prices often fall. This has been the case for much of the last 30 years and enables investors to benefit from the only free lunch in markets – diversification (Chart 3).

Chart 3. Most of the past 30 years saw a negative correlation between bonds and equities

Supply-side shocks are different, as they push growth and inflation in opposite directions and therefore, push bond and equity prices in the same direction (positive correlation). This has been the case for much of the last couple of years and undermines the standard portfolio diversification characteristics. For the majority of the pre-Volker era, bonds and equities had a positive correlation.

Taking the example of a 60% allocation to US equities and a 40% allocation to US government bonds, rebalanced monthly, the chart shows the ratio of the net portfolio volatility and the sum of the standalone volatility of the assets held in the portfolio. The ratio is the diversification benefit between the two assets (Chart 4).

Chart 4. The diversification benefit of combining bonds and equities has fallen since the pandemic as inflation volatility has increased

Final thoughts

If inflation volatility is higher than in the past 30 years, we believe it is unlikely that combining bonds/equities will yield the same diversification benefits as in the past. Investors seeking to improve their risk-adjusted returns may need to focus on finding alternative low-correlated assets/strategies.

Important information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).