However, when looking at the current inflationary environment, Wayne is encouraged that all the key drivers of inflation — like wages growth, headline CPI, and money supply — are falling in the United States, which is positive for the global economy.

Wayne says it’s a similar story in Australia, where considerable progress has been made fighting inflation. However, he notes that despite the July headline CPI slowing from 5.4 per cent to 4.9 per cent, the August headline CPI surprised to the upside, increasing 0.3 per cent to 5.2 per cent.

“However, core measures are much stickier, with trimmed mean inflation of 5.6 per cent year-on-year and ex volatiles inflation of 5.8 per cent year-on-year,” he says. “Going forward, we believe core inflation trends, wages and unemployment will remain key to the RBA’s policy.”

In terms of the long-term forecast on inflation, Morgan Stanley believes that by the end of 2024, the U.S. will fall to its target rate of 2 per cent, and Australia will drop to 3.1 per cent. And while this is good news for the economy, it also implies that the market shouldn’t be expecting any cuts to interest rates soon.

“There’s still a bit of work to do,” says Wayne. “Inflation can be very sticky, so we might be at these rates for a little while to come.” 

It’s a view largely supported by Dr Isaac Poole — Chief Investment Officer at Oreana Portfolio Advisory — who also adds: “The key question when discussing inflation is: Do you believe inflation will be structurally higher for longer? Because if you do, it is absolutely critical for your portfolio construction.”

According to Isaac, if you believe inflation is going to be higher for longer, then you need to start building that into your portfolio. This means if you believe that either equity risk premia has fallen, equity volatility has fallen, bond volatility has increased, or the covariance between these two asset classes has changed, then investors need to rethink their long-term strategic asset allocation (SAA). 

However, Isaac doesn’t believe inflation will be higher for longer. Instead, he believes inflation will come back relatively quickly, and even predicts deflation next year, as a result of a recession. But over the long run, he believes inflation will settle back at the Fed’s (2 per cent) and RBA’s (2-3 per cent) long-term target.

So, how confident is Isaac with his view of inflation not being higher for longer?

“The reality is, it’s hard to be confident either way when it comes to long-term assumptions,” he says. “The way we manage inflation is we don’t build a SAA based on point estimates for our long-term capital market assumptions. Yes, they feed into scholastic optimisers and we can get point estimates, but we run scenario analysis and allow things to move around those long-term numbers.

“And so, while you won’t have a particularly high level of confidence on any individual point, you can build a process that allows you to have a higher level of confidence that your SAA will achieve your investment objective, and that’s really the goal.”

Jeff Mitchell — Chief Investment Officer at Infocus Securities — says the inflationary environment we’re currently in is a direct consequence of the COVID pandemic, which saw global lockdown, supply chain issues, and stimulus spending.

“The RBA delivered a cumulative 400bps of interest rate tightening over 13 months, as it joined other central banks in trying to tackle inflation. However, we believe central banks have probably done enough. The next two quarters will really be the measure of how well they’ve done,” says Jeff. “But it’s worth remembering that the current inflation rate is still not that high — 5.2 per cent in August — compared to the high inflation rates of the 1970s. So, our view is that inflation will soften, but not disappear entirely.”

According to Jeff, post-GFC, the economy was basically in a zero inflationary environment, but that’s all changed, and now we’re in an environment where inflation is expected to settle back to the RBA’s long-term target of between 2-3 per cent.

“Once the inflation genie is out of the bottle, it’s hard to put it back in,” says Jeff. “We could get another spike in inflation. Post-COVID spending really hit hard, which amplified the impact on the market. If consumer spending and consumption is to persist and keep upward pressure on prices, then inflation is not going to completely disappear again.”

He says the only way inflation is likely to get back to zero will be as a result of really bad monetary policy, leading to a stiff recession.

“That will drive inflation back to zero, but do you really want to go there? Instead, I believe a longer-term scenario will see inflation move back into the 2-3 per cent range. The mechanisms for inflation management and economic management are a lot stronger now than they were 10-20 years ago.”

Given advisers are constructing portfolios for clients either in or approaching retirement, Jeff says Infocus keeps its clients front and centre when developing portfolios, which includes managing various risks, such as drawdown risk and sequencing risk, as well as keeping a close eye on inflation.

“Many advisers in our network use a bucket strategy when building portfolios, and within that bucket strategy, we have a focus on income, preservation of purchasing power, and drawdown,” he says.

Essentially, the bucket strategy involves segmenting a client’s capital into two or more pools or buckets (usually three buckets). For example: a ‘cash bucket’ with safe investments for pension payments expected over the short-term (three to five years); and an ‘investment bucket’ invested in growth assets, like equities and property, for the intermediate or long-term.  

“So, in retiree portfolios, we use a bucketing approach. The portfolios we are constructing for retirees focus a lot more on drawdown and income. However, this approach means we potentially miss out on big market rallies, but we do preserve a lot more capital for our clients, because we manage the drawdown risk in our portfolios.” 

It’s an approach Isaac endorses: “There are different objectives you’re managing for retiree clients. People who are looking for income now have access to a range of assets that are delivering income for the first time in many years. This provides advisers with a broader opportunity set to manage to at the moment, which is great for retirees and clients approaching retirement.”