Perspectives – Inflation expectations are reaccelerating, what does this mean for asset allocation?

Inflation has been under the spotlight over more recent years, having been dormant over the previous 30 years or so. The lockdown related inflation eruption is widely believed to have given way to a state of inflation dormancy again. It’s believable for a number of reasons, but these reasons are largely emotional, rather than grounded in fact.

For example, it’s believed by many that it’s normal to have a low inflation environment, despite the evidence that since at least 1900 inflationary episodes have dominated. On top of that, the last 30 years of atypically low inflation have been broadly positive for financial markets. So, it’s easy to see why investors might want to believe that “this time it’s different”, especially if they look back over their career, which most likely wasn’t punctuated with inflation (putting aside the most recent “blip”).

These are of course backward-looking arguments and, whilst more investors probably accept that inflation in many economies is currently stubbornly high, the actual level doesn’t appear worryingly high.

However, we don’t think inflation will drift back to central bank targets and obediently stay there. We have been saying this for a number of years and our higher for longer view has dominated asset allocation across the Macro Thematic Multi Asset range. We believe there are some powerful structural forces, such as deglobalisation and expansive fiscal policy, which will push inflation to levels that central banks are uncomfortable with.

Indeed, when more forward-looking data is objectively assessed, it becomes more insightful. Specifically, inflation expectations have been rising. Inflation expectations are often believed to be simply a leading indicator of inflation but actually inflation expectations are also drivers of realised inflation, i.e. expectations feed into realised inflation. Therefore, it will come as no surprise that the Fed, for example, look to anchor expectations at roughly 2% over the long term.

Indeed, the anchoring of inflation expectations is also fascinating, as this helps gauge the degree to which expectations are insensitive to higher inflation data. For example, if higher shorter term inflation expectations don’t lead to higher medium term inflation expectations, that would give the Fed some comfort. However, if short term inflation expectations are moving higher at the same time as medium term inflation expectations that would be a cause for concern. This is what is happening currently.

The University of Michigan Inflation expectations survey is supposedly closely followed by investors but there seems to be little headline coverage currently. The one year inflation expectation stands at 4%, while the two year inflation expectation now stands at 3.2%. Historically, the level of expectations from these surveys have been higher than realised consumer price inflation, so it’s best to focus on the trend. Fascinatingly, the five to ten year number is close to a 17 year high, and even the short term survey is at a one year high, though we see little coverage of either fact.

However, this data will be of some concern to the Fed. Moreover, it’s not just the inflation surveys that show a resurgence in expectations, market expectations of inflation are also showing a resurgence, as shown by the US break-even rates below, over short and medium term times periods.

Source: Bloomberg Finance L.P 12.12.2025 – 14.02.2020

How have rising inflation expectations translated into the all-important outlook for US interest rates? The market has been moving towards a higher for longer view in terms of interest rate expectations. For example, back in September markets expected US rates to have been cut to 3% by June this year. That figure now stands at 4.2%, very close to where rates are currently. That is a material adjustment but actually one which markets have dealt with pretty positively.

Nevertheless, flexibility by the Fed is now limited, due to building inflationary pressures, and is complicated by a growing political pressure to cut, as well as the noise around tariffs and what that might or might not mean for inflation. Of course the Fed doesn’t just have power through changes in rates, they have significant power through their communications, assuming they continue to retain their credibility.

What can we say about our positioning in this environment? We believe it’s probably best to be fairly fully weighted in equities, they are real assets after all, and unless something significant suggests otherwise, the trend is your friend and the trend is for positive momentum.

In bonds we remain short duration, in order to limit interest rate risk in our inflation base case. We also think longer duration bonds won’t provide diversification of risk assets, even if short duration bonds might dilute equity market volatility. Instead we look for some diversification from commodities, which tend to be more negatively correlated to equities in inflationary periods, and we retain material exposure to gold and some to agricultural commodities and oil. In terms of currencies, we retain our material exposure to the US dollar, which should also be supported by rising inflation expectations in the US.

Anthony Rayner

Premier Miton Macro Thematic Multi Asset Team