How to Rethink Your Portfolio for Long-Term Inflation

Mar 29, 2023

If rising inflation becomes the norm for years to come, how can investors prepare?

Dan Hunt

Key Takeaways

  • After 40 years of declining inflation in the U.S., it is now entirely plausible that a new era of persistently rising inflation is underway.
  • If rising inflation does become an entrenched trend, investors may need to reduce portfolio withdrawals to help preserve their assets. 
  • Bonds and other investments typically considered “lower risk” may offer less stability and diversification potential.
  • However, international stocks, commodities, real estate and cash may become more important sources of return and diversification.

The Federal Reserve’s aggressive interest-rate hikes are helping tame inflation—for now. But what if the pressures that sparked last year’s decades-high consumer price inflation stick around longer than expected?


Morgan Stanley’s Global Investment Committee believes it’s important to remember that, despite the last 40 years of falling inflationary pressures in the U.S., the reversal of this trend is entirely possible as well. Indeed, our indicators suggest that the U.S. is in a period of accelerating structural inflation for the first time in decades, and it is plausible that this will continue for the foreseeable future.


That could have significant implications for investors. 


Until 2022, a whole generation of investors had grown accustomed to certain assumptions about how bonds, stocks and other asset classes typically behave amid the market’s ups and downs in a lower-inflation environment. But if recent inflationary pressures persist, such longstanding assumptions may no longer apply, and investors may need to rethink their portfolios as a result.

The recent decades of cooling inflationary pressures have not historically been the norm.

Here’s a closer look at how price pressures have fluctuated over time and how spending plans and portfolio construction may need to change if hotter inflation is here to stay.



Inflation Has Varied Throughout History

The recent decades of cooling inflationary pressures have not historically been the norm. The consumer price index (CPI), a key inflation gauge, swung drastically in the early part of the 20th century, pushing the U.S. economy from a Depression-era stretch of slowing growth and cooling inflation, or “stagnation,” to an inflationary boom of rapid economic growth during and after World War II. In contrast, the late 1970s and early 1980s brought a period of weakening economic growth and accelerating inflation, widely known as “stagflation.”


Altogether, only about 60% of the last century saw slowing inflation; the other 40% saw accelerating inflation. 


Spending Assumptions May Need to Change With the Times 

After such a long stretch of cooling inflationary pressures, assuming the future will hold “more of the same” could be a mistake. In particular, it could lead investors to overestimate the sustainability of their existing spending plans or budgets.


Imagine a 60-year-old with a portfolio of 20% equities, 75% fixed income and 5% cash. Based on our modeling, if we assume that inflation will cool and growth will pick up in the years ahead, we might conclude that this investor can safely withdraw 3.3% of her portfolio annually, with minimal risk of running out of money during her lifetime. However, if inflation instead heats up and the economy slows, a safe withdrawal rate would fall to just shy of 2.9%. Such a difference might seem small, but it in fact represents a reduction of about 12% in her potential spending power. 


Investing During Inflation

Assuming “more of the same” could also lead investors to misjudge the risk, return and diversification potential of their portfolio. Allowing for the historical possibility of structural inflationary pressures, for example, our strategists would recommend smaller allocations to interest-rate-sensitive equities, such as large U.S. growth stocks, than would have been beneficial in prior investing climates.

Assuming 'more of the same' could lead investors to misjudge the risk, return and diversification potential of their portfolio.

There are two critical shifts in the way asset classes may behave in a persistent-inflation environment.


First, asset classes typically considered “lower risk” may offer less stability and less potential for diversification during inflationary periods. For example, bonds have long been prized for being less volatile than stocks, but as investors saw in 2022, fixed income can be highly volatile and more closely correlated to stocks when inflation is rising. If this trend persists, investors may need to rethink popular strategies, such as the 60/40 portfolio, which are based on assumptions about low fixed-income volatility and stable correlations between equities and bonds.


Second, persistent inflation may make certain asset classes more attractive. For example:


  • International equities may have higher diversification potential and, on a risk-adjusted basis, could outperform U.S. growth stocks, which prior to 2022, dominated benchmark stock indices for many years.
  • Real assets, such as commodities and publicly traded real estate, could offer more diversification potential amid higher inflation. Commodities are known to perform well because inflation tends to boost their prices. Similarly, real estate investment trusts (REITs) may benefit when inflation and interest rates are elevated, especially in stagflationary environments.
  • Cash can also play a bigger role in diversifying portfolios when inflation is rising. During the decades-long bull market in bonds, many investors sought to minimize cash in their portfolio, since it did not offer attractive risk-adjusted returns compared to fixed income. However, that may no longer be the case. In recent months, for instance, cash equivalents such as Treasury bills and many high-yield savings accounts have been offering higher yields than longer-dated U.S. government bonds while not suffering through the volatile swings in interest rates that have caused drawdowns in fixed income portfolios. 


Whether the future holds higher-for-longer inflation or we see inflation tamed quickly and rates brought back down to recent historic levels is unclear. What is certain, however, is that the sooner investors learn to adjust to the possible new economic outlook, the better off they may be. 


Connect with your Morgan Stanley Financial Advisor to request a copy of our team’s report,What if the Future Is Inflation? Correcting Disinflationary Bias in Market Forecasts.” Your Financial Advisor can offer guidance on how you can position your portfolio for potentially different economic environments in the future.

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