While inflation is expected to remain subdued in the near term, leading asset managers are still hedging against the risk of an inflation surprise in 2021.

“A potential risk is an inflation surprise. We expect that inflation globally will remain subdued in the near term as the effects of the pandemic keep the prices of goods in check. However, large fiscal injections, climbing government debt, and accommodative central banks could lead to higher inflation in a post-Covid world,” says Erin Brown, managing director and asset allocation portfolio manager at Pimco, and Geraldine Sundstrom, managing director and portfolio manager, asset allocation, at Pimco, in their latest investment outlook.

This warning is echoed by BlackRock, which says new central bank policy frameworks are likely to keep interest rates low, even in the face of rising inflation in the long term.

“We believe markets underappreciate inflation risks and that the coming higher inflation regime will be very different from the reflation debates of the last expansion. Central banks have signaled they will be more willing to let economies run hot with above-target inflation by changing their policy frameworks to make up for prior inflation undershoots,” says Jean Boivin, head of BlackRock Investment Institute, in BII’s 2021 Global Market Outlook.

The rise in inflation is expected to come from the unprecedented cooperation between fiscal and monetary authorities as they struggle to counter the adverse effects of Covid-19.

“This has upended the policy landscape. We see no political appetite for fiscal austerity, even as debt ratios hit historic highs globally. The politics of inequality will likely keep deficit spending high,” says Boivin. “We are already seeing signs of a risk that central banks become more politicized in the new investment order. This comes as we expect rising production costs amid a focus on supply chain resilience and greater pricing power of large companies in this environment.”

Because of the prospects for rising inflation, Pimco is focusing on assets that can serve as both an inflation hedge and a diversifier in a scenario of weakening economic conditions.

“This includes inflation-linked bonds and gold, which we believe provide a good store of value over the long term with a low correlation to traditional risk assets. We are avoiding more growth-sensitive real assets – such as energy commodities – given our expectations for a gradual economic recovery with meaningful downside risks and low or negative real yields for years to come,” say Brown and Sundstrom.

Government bonds will continue to be a reliable source of diversification against a growth shock despite yields at historically low levels. US treasuries have more room to rally than most developed market inflation regimes in the next five years. It means stronger growth in the near term, and eventually higher inflation - without the typical rise in nominal bond yields.

“As a result, we see very different market implications than in the past. Previous episodes of rising inflation were costly for investors, leading to higher interest rates that pressured valuations across asset classes via rising discount rates. Yet the policy revolution means any rise in inflation from today’s levels will be better for risk assets than in past episodes, in our view,” says BlackRock.