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Chain reaction

The accelerating oil price and other raw material price increases have created a very difficult investment climate. Inflationary pressures are gathering momentum, yet global economic growth is declining, presenting a tricky dilemma for central banks. Unsurprisingly, most financial markets have struggled over recent months.

Stagflation presents a major challenge for traditional multi-asset funds but solutions which actively allocate to alternative investments can benefit from a broader range of assets that often exhibit varying behaviours in the face of rising inflation.

Commodities are often the best performing asset in the early stages of an inflationary cycle. They are also one of the few investments that have historically delivered positive real returns throughout a high inflation period. Meanwhile, infrastructure tends to be a good long-term inflation hedge as ongoing cash flows – road tolls and airport usage charges, for example – tend to increase with inflation.

Equities usually form a big part of multi-asset strategies due to their potential to deliver high capital growth. What can we expect as inflationary pressures take their toll? Areas that tend to hold up well are those that have the pricing power to pass inflationary cost pressures on to prices. This tends to work its way through the value chain.

The first sector to benefit from the high oil price is resource companies in the oil and gas industry. Next to profit will be areas that support commodity extraction and production. As resource firms race to capitalise on higher commodity prices by expanding production, companies that manufacture oil and gas mining equipment also gain. Eventually, industrial stock performance tends to improve when manufacturers can pass on price increases to retailers. For example, we are beginning to see big retailers finally capitulating to Chinese suppliers demanding price rises.

It is for these reasons that regional selection is also key. Countries that are net commodity exporters or have more pricing power in their manufacturing sectors tend to hold up better. However, net-debtor nations can benefit from inflation as it diminishes the value of their debts to net-creditor nations. Overall, we think sector and regional selection will become critical due to the narrowing range of equities potentially offering positive returns.

If the oil price softens, other asset classes have the potential to recover strongly. In the meantime, we expect the returns of various assets to be significantly more differentiated, given the unsettled investment climate.

Johanna Kyrklund is head of UK multi-asset at Schroders

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