Drawing from survey data collected over the past 25 years, the Nobel-prize winning economist Robert Shiller and his colleagues revealed that investors tend to overestimate the probability of a major crash similar to those experienced in 1929 or 1987. The perceived likelihood of such a crash is significantly higher than the actual historical probability of such events occurring. It appears that when there are some resemblances to present circumstances, individuals tend to redirect their focus toward past narratives, explains Shiller. Considering the role fear plays, there is a possibility that a negative, self-fulfilling prophecy could take hold.  

This emphasizes the significance of maintaining a well-diversified portfolio across different asset classes. Even in hard and fearful times, investors can capitalize on opportunities that arise from the fluctuating nature of volatility itself. The key is to find that harmonious blend between yin and yang that matches one's financial objectives, time horizon, and risk tolerance. 

If we were to invest now or consider investing given that we know inflation is here to stay for a longer period of time, how and based on what would we make our investment decisions? To answer that, Allianz Global Investors (AllianzGI) looked at how different types of investments responded in very different inflation environments from 1971 to the present.

AllianzGI examined time periods during which inflation in the U.S. was at least 2% and increasing on a yearly basis. This choice was based on the belief that it represents the most probable scenario for the foreseeable future. The analysis focused on the year-over-year performance, measured in U.S. dollars of various asset classes including U.S. cash, U.S. government and corporate bonds (fixed income), U.S. and global equities, and commodities.

1. Equities: a hedge worth considering 

Broadly speaking, equities represent the financial worth of a business, taking into account all assets and debt of that business. It symbolizes ownership, granting individuals the entitlement to future profits, company growth, and the ability to participate in decision-making through voting rights. Investing in equity allows individuals to become shareholders in public or private companies. 

Analysis showed that equities are a hedge worth considering at an inflation rate somewhere between 2% and 4%, which is the most likely range of inflation in the period to come. Research indicates that equities have historically delivered robust inflation-adjusted returns at this level, outperforming bonds. Equities, being tangible assets, may serve as a reliable safeguard against potential inflation surprises. 

However, it is important to note that U.S. equity valuations are already quite high, which could limit the potential returns. Additionally, it is not just the inflation rate itself but also the volatility of inflation that affects equity valuations. Therefore, long-term expectations for absolute returns on equities are moderate. 

2. Fixed income: positive investment returns are achievable even as inflation increases 

While equity investors become owners of companies, fixed-income investors finance their debt. Larger companies typically refinance themselves via both, issuing equity (stocks, shares) and borrowing capital—be it in form of bank loans or by issuing bonds that are sold on the fixed-income market. Fixed-income investment therefore is a category of investment focused on the preservation of capital and one which entails consistent and regular returns for investors. By investing in such bonds, investors are entitled to a series of regular interest payments that are considered as fixed income. These investments are less volatile than the stock market and can balance out the risk in the portfolio to offset volatility during a stock market downturn.  

Inflation, however, has a substantial impact on fixed-income investments. While inflation increases, the interest rates offered by fixed-income instruments remain the same. Consequently, investors are compelled to seek alternative options that can provide returns higher than the inflation rate. This is necessary if investors wish to outpace inflation and prevent the erosion of the purchasing power. Last year, when inflation reached 10% in the euro area, the interest rates generated by many fixed-income investments fell well short of the higher inflation rate. 

Nevertheless, for active fixed-income investors who have the necessary flexibility and ability to make strategic moves, inflation, like any other risk, can also present opportunities. Active managers have opportunities to generate favorable returns in such circumstances. They can aim to generate returns by strategically positioning themselves and reallocate money within and in-between financial-market segments, avoiding those assets that suffer most from inflation and shifting to those that may even benefit from it. 

“Understanding the drivers of government bond yields and how to use these tools are critical skills when the inflation outlook is uncertain, because they allow active managers to take advantage of both rising and falling inflation expectations. This can be accomplished either via direct investments in inflation or in combination with other risk premia, as part of a holistic approach to duration and curve positioning in government bonds,” explains Jan King, Product Specialist, Fixed Income at AllianzGI. 

3. Commodities: strong historical performers in times of inflation, but climate change could dampen the outlook 

In the majority of inflationary circumstances, commodities have historically outperformed equities. However, the future prospects for commodities remain uncertain. One the one hand, economic policies aimed at addressing climate change may pose challenges for energy commodities.  

On the other hand, the demand for industrial metals, particularly copper due to its efficient heat and energy conduction properties, is expected to be strengthened by decarbonization. 

4. Private markets: compelling option for institutional investors seeking a hedge against inflation 

Institutional investors could also explore the possibility of investing in privately-held companies' debt or equity. Private markets offer an attractive complexity premium despite rising normal rates and can serve as a hedge and potentially offer advantages in the face of a prolonged period of inflation. This can be attributed to their long-term buy-and-hold characteristics and their capacity to pass on increased costs. According to Preqin, the demand for private capital will continue to grow despite the challenging macroenvironment but at a slower pace, with total global assets under management (AUM) expected to almost double to USD 18.3 trillion by the end of 2027. 

In particular, private debt and infrastructure are the most attractive asset classes at the moment. Private debt is typically structured around floating-rate notes, which means that the interest rate is variable. As such, it offers protection against an environment of rising rates and inflation. Also, the duration of each investment is typically shorter than equivalents on the public markets, so managers can be more proactive in responding to inflation. 

Infrastructure assets often have features and contractual protections which allow to navigate periods of high inflation. Infrastructure investments—in comparison to other forms of corporate debt—are  considered relatively low-risk assets with an investment-grade rating. They have a long duration, providing investors with a level of confidence in meeting their long-term obligations. Additionally, infrastructure investments are not as susceptible to market risks compared to publicly-traded corporate sectors, resulting in lower volatility. 

"Private-markets strategies may hold opportunities for investors to find yield and access returns, whether through identifying the sectors and companies that are positioned to flourish during an inflationary environment, or through a structure that delivers a close correlation with inflation. For many, a return to inflation will not be feared. In the context of these strategies, it could even be welcomed," said Emmanuel Deblanc, Head of Private Markets at Allianz Global Invstors. 

Considering that any degree of inflation diminishes future buying power, one effective strategy to counter inflation is to increase savings and start investing at an earlier stage. This enables your portfolio to benefit from the compounding effect. Additionally, it is crucial to evaluate the real yield of your investments by accounting for the impact of inflation. 

Overall, it is important to understand all the factors that might influence your investment decisions and style—from stress and fear to the performance of different asset classes during periods of inflation. Investment options and styles do not have to be exclusively black or white, but can also fall somewhere in between and be focused on diversification. It is essential to cultivate flexibility, focus on quality, and consider the long-term perspective.