The Ukraine invasion has also reduced the global supply of wheat, cooking oils and other key commodities, impacting overall food prices. Droughts and floods have also reduced food supply. War and extreme weather conditions mean a wider range of potential outcomes.
What has improved are the bottlenecks that reduced manufacturing activity in 2020 and 2021. Fewer lockdowns and less pressure on shipping and distribution is evident in measures such as the New York Fed Global Supply Chain Pressure Index. If these trends continue, it will remove a major driver of higher goods prices.
On balance, demand and supply factors are acting to bring inflation down in years to come. There are many wildcards that make the range of outcomes wider than usual, including the evolution of the Russia/Ukraine war, changes in global supply chains, technological advances and acts of nature from pandemics to droughts and floods.
Dealing with uncertainty
Uncertainty about the inflation outlook means that it is risky to build a portfolio that performs well only in a specific inflation scenario. In fact relying on any specific economic or market forecast is risky, given the poor track record of professional forecasters, the complexity of the global economy and the randomness of shocks.
Here are three ways to deal with uncertainty in a more reliable way.
Firstly, consider a range of feasible scenarios over a full economic cycle when assessing how much to pay for an asset. Assets that already reflect a feasible worst-case scenario are more likely to withstand adverse conditions.
They are also more likely to generate higher returns than those that already reflect the feasible best-case scenario. This means undervalued assets stand a better chance of outpacing inflation because their return is more likely to be higher than other assets in most scenarios.
Secondly, search far and wide to identify as many opportunities as possible by getting as granular as possible when researching markets. This increases the chances of identifying different opportunities that are less correlated to other equity, bond and currency markets.
Thirdly, use scenario analysis to identify effective diversifiers by assessing the conditions under which a portfolio of attractive opportunities might perform poorly and from this assess diversifying assets including currencies.
Following this approach led us to buy heavily into assets with inflation-hedging characteristics such as energy shares in 2020, when these were pricing in very low inflation outcomes. They do not point to buying these assets today because their prices reflect much higher inflation expectations.
Portfolio positioning
High inflation is now priced in to a much greater degree in inflation-sensitive assets like energy companies and inflation-linked bonds, making them less attractive as sources of return and diversification.
