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Positioning Portfolios for An Environment of High Inflation

Investors should adopt inflation protection as inflation shows few signs of moderating anytime soon and central banks are tightening monetary policy aggressively. Treasury Inflation-Protected Securities (TIPS) can help position portfolios for an environment of higher inflation and lower growth. TIPS protect against inflation in two ways. First, the principal value of TIPS is indexed to inflation. When inflation increased by 7.5% in 2021, so did the principal value of TIPS. Second, the coupon payments of TIPS are also inflation adjusted, with payments based on the inflation-adjusted principal value of the TIPS multiplied by the coupon rate. TIPS also maintain the defensive components of Treasuries, should growth expectations decline.

In addition to allocating to TIPS, investors also need more yield to help protect from diminishing purchasing power, given the negative real yield starting point of TIPS. One solution is to replace the Treasury allocation in a multi-sector bond portfolio with TIPS. The multi-sector portfolio provides a more appealing risk-return profile, in addition to a yield cushion. Corporate bonds and securitized debt boost portfolio yields and are less sensitive to interest-rate risk. The interplay between yields, volatility and the shape of the yield curve could create investment opportunities in rate markets and among securitized assets. Investors should also build protection into their strategic asset allocations, which pertains to the long term.

Moreover, a blend of assets and hedges can overcome these drawbacks and prove worthwhile for inflation-sensitive investors because different asset classes outperform in different macro regimes. Such assets include stocks with pricing power, inflation-protected bonds, inflation swaps, floating rate debt, and real assets like commodity futures, real estate, infrastructure and commodity-linked stocks. A balanced allocation to these assets can increase the robustness and resilience of portfolios and allow investors to successfully navigate the hostile markets inflation may cause. I also recommend considering high-yielding bonds and broadening the horizon. Inflation is higher globally but it varies by region and country. In brief, active management is key in this environment because only active investors can respond nimbly to fluctuations and navigate shifting trends.

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