How to rethink your portfolio for long-term inflation

The Federal Reserve’s aggressive interest-rate hikes are helping tame inflation—for now. But what if the pressures that sparked last year’s decades-high consumer price inflation stick around longer than expected?

Morgan Stanley’s Global Investment Committee believes it’s important to remember that, despite the last 40 years of falling inflation in the US, the reversal of this trend is entirely possible as well.

What does this mean for investors?

Until 2022, a whole generation of investors had grown accustomed to certain assumptions about how bonds, stocks, and other asset classes typically behave amid the market’s ups and downs in a lower-inflation environment. But if recent inflationary pressures persist, such longstanding assumptions may no longer apply, and investors may need to rethink their portfolios as a result.

Here’s a closer look at how spending plans and portfolio construction may need to change if hotter inflation is here to stay.

Assuming the future will hold “more of the same” cooling inflationary pressures that have existed for decades could be a mistake, in part because it could lead investors to overestimate the sustainability of their existing spending plans or budgets.

As an example, imagine a 60-year-old with a portfolio of 20% equities, 75% fixed income, and 5% cash. If it’s assumed that inflation will cool and growth will pick up in the years ahead, you could conclude that this investor can safely take out 3.3% from their portfolio annually, based on modeling from the Global Investment Committee, with minimal risk of running out of money during their lifetime.

However, if inflation instead heats up and the economy slows, a safe withdrawal rate would fall to just shy of 2.9%, which represents a reduction of about 12% in their potential spending power.

There are two critical shifts in the way asset classes may behave in a persistent-inflation environment.

First, asset classes typically considered “lower risk” may offer less stability and less potential for diversification during inflationary periods. For example, bonds have long been prized for being less volatile than stocks, but as investors saw in 2022, fixed income can be highly volatile and more closely correlated to stocks when inflation is rising. If this trend persists, investors may need to rethink popular strategies, such as the 60/40 portfolio, which are based on assumptions about low fixed-income volatility and stable correlations between equities and bonds.

Second, persistent inflation may make certain asset classes more attractive. For example:

• International equities may have higher diversification potential and, on a risk-adjusted basis, could outperform US growth stocks.
• Real assets, such as commodities and publicly traded real estate, could offer more diversification potential amid higher inflation. Commodities are known to perform well because inflation tends to boost their prices. Real estate investment trusts (REITs) may also benefit when inflation and interest rates are elevated, especially in stagflation environments.
• Cash can also play a bigger role in diversifying portfolios when inflation is rising. During the decades-long bull market in bonds, many investors sought to minimize cash in their portfolio, since it did not offer attractive risk-adjusted returns compared to fixed income. However, that may no longer be the case. In recent months, cash equivalents such as Treasury bills and many high-yield savings accounts have been offering higher yields than longer-dated US government bonds while not suffering through the volatile swings in interest rates.

Whether the future holds higher-for-longer inflation, or we see inflation tamed quickly and rates brought back down to recent historic levels is unclear. What is certain: The sooner investors learn to adjust to the possible new economic outlook, the better off they may be.

The source of this article, How to Rethink Your Portfolio for Long-Term Inflation, was originally published on March 29, 2023.