Investment Strategies
Inflation And What It Means For Asset Allocation, Markets

The author of this article argues that the resurgence of inflation and the recent interest rate hikes have substantial implications for the private equity and funds industry, as well as international financial centres worldwide.
The rises in interest rates by a number of major central
banks have been a jolt to wealth advisors and their clients who
had been used to more than a decade of ultra-low rates. Rising
inflation – driven by a variety of causes, such as massive
central bank quantitative easing – revived unwelcome memories of
the 1970s and 80s, and the struggles to contain it. The return of
inflation has upended asset allocation, risk management, and the
goals of HNW individuals. It has also come at a time when other
big trends in investment, such as ESG, have been powerful, and it
has impacted these.
In this article, Geoff Cook, chair of Mourant
Consulting, looks at the landscape. Readers may recall that
Geoff was for many years the CEO of Jersey Finance, and a
prominent defender of international financial centres.
The editors are pleased to share this content and invite replies.
The usual disclaimers apply. Email tom.burroughes@wealthbriefing.com
Recently, inflation reached multi-year highs due to several
factors. During the pandemic, central banks injected significant
quantitative easing stimulus into economies, especially the
Federal Reserve in the US. Stimulus funds from the Biden
administration further exacerbated the situation.
These events led to a significant increase in the money supply
amid supply-side shortages caused by the pandemic. The war in
Ukraine further increased inflation, with food and energy prices
skyrocketing. In Britain, Brexit-induced labour shortages and
rising wages worsened the inflation situation. Once wage
inflation sets in, it becomes difficult to curb and a driver of
core inflationary pressures.
Eminent economists like Mervyn King and Andy Haldane argue that
central banks underestimated the monetary impact of quantitative
easing and developed blind faith in the Modern Monetary Theory
(MMT) inflation concept. In the MMT framework, inflation becomes
a concern only when the economy reaches full employment and
productive capacity. They propose that taxation can be used as a
tool to control inflation. This miscalculation has led to
concerns that the current tightening cycle may not be enough to
control inflation, especially in the UK, where labour shortages
have been particularly acute.
The risks of over-tightening monetary policy are substantial and
include business failures, mortgage foreclosures, unemployment
and recession. Central banks may adopt a more conservative
approach due to criticism of their role in stoking inflationary
pressures. However, excessive tightening can also be detrimental,
as it takes 18 months to two years for the full impact of
interest rate increases to materialise.
Confidence in central bank modelling has been undermined as they
initially predicted inflation to be transitory rather than
structural. The Bank of England has enlisted the help of Ben
Bernanke, former chair of the Federal Reserve, to examine their
modelling and recommend changes.
With faith in their models shaken, the Bank of England now makes
interest rate decisions based on near-term indicators, analysing
monthly data point by point. This cautious approach has
drawbacks. It's akin to walking while looking at one's feet,
leading to potential collisions with unforeseen obstacles, like
walking into a lamppost.
Overall, the central banks face a delicate balancing act in
managing inflation and interest rates, and their decisions will
have significant implications for the economy, people's
livelihoods and investment decisions.
The resurgence of inflation and the recent interest rate hikes
have substantial implications for the private equity and funds
industry, as well as international financial centres (IFCs)
worldwide. As inflationary pressures continue to mount,
investment decisions become more complex, and portfolio managers
must adapt their strategies to navigate this uncertain economic
environment.
Market volatility and asset valuations
Heightened inflationary pressures can lead to increased market
volatility, impacting asset valuations across various sectors. As
prices fluctuate, private equity and funds may experience
challenges in accurately valuing their investments, particularly
in sectors sensitive to inflation, such as commodities, real
estate, and energy. Additionally, investors may witness a shift
in the performance of different asset classes, requiring agility
in asset allocation to manage risk and capitalise on emerging
opportunities.
Interest rate sensitivity
The trajectory of interest rate hikes in response to inflationary
pressures directly affects the private equity and funds industry.
Rising interest rates can result in higher borrowing costs,
affecting leverage levels and financing options for acquisitions
and investments. Funds with significant debt exposure may
experience increased interest expenses, impacting their overall
profitability. Moreover, IFCs, being hubs for global capital
flows, may experience shifts in their competitiveness as interest
rate differentials influence fund flows and investment
attractiveness. Still there is a silver lining in the inflation
cloud for some. Banks in IFCs have struggled with profitability
in the era of ultra-low interest rates but are finally seeing
improved margins and profits whilst rewarding savers with higher
returns.
Portfolio diversification and inflation
hedges
In response to the evolving inflation landscape, private equity
and funds may consider adjusting their portfolio diversification
strategies. Investors may seek to include inflation hedges, such
as inflation-protected securities, commodities, or real assets,
to safeguard against the erosion of real value in their
portfolios. Diversification across geographies and industries
becomes crucial to mitigate concentration risks and capitalise on
regions or sectors better positioned to withstand inflationary
pressures.
Regulatory scrutiny and reporting
As inflation concerns persist, regulators may intensify scrutiny
on investment practices and risk management within the private
equity and funds industry. Investors may face increased reporting
requirements to provide transparency on strategies to manage
inflation-related risks. IFCs may also revise their regulatory
frameworks to ensure the industry's resilience in the face of
inflationary challenges and to maintain their global standing as
reliable financial centres.
Peak inflation presents a dynamic and challenging landscape for
the private equity and funds industry and IFCs. As inflation
theories remain contested, careful risk assessment and adaptation
of investment strategies become paramount. The industry must be
prepared to navigate the uncertainties, leverage diverse
inflation views to make informed decisions, and remain agile in
managing portfolio risks to ensure sustainable growth and value
creation in the face of inflationary pressures.
For IFCs, proactively addressing market volatility and evolving
regulatory demands will be instrumental in maintaining their
status as attractive and competitive financial centres amidst the
shifting economic landscape.