In 2021 the rate of inflation in the US rose to 7.0%, the highest rate for any year since 1981. While most professional forecasters, including most members of the Federal Reserve (Fed), anticipate a reversion to the low inflation observed since the mid-1990s by 2023, there is a non-trivial probability that inflation and inflation uncertainty could stay elevated for at least the next few years. If such an environment were to persist, investors should be alert to the dynamics higher inflation introduces into the broader economy and ultimately, into asset returns. To evaluate the potential impact of a regime of higher inflation on portfolio returns, we look at both historical and forward-looking portfolio outcomes, assuming inflation remains elevated for the next five years. Traditional allocations to equities and bonds in an environment of elevated and uncertain inflation are likely to perform poorly in nominal and particularly in real terms. Investors should consider larger allocations to asset classes with a positive direct exposure to inflation, such as commodities and real estate, given their historical strength in high-inflation environments.
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