Investors face structurally higher inflation risks than pre-COVID. Most portfolios remain poorly equipped to manage them.
This year, we have written extensively about the three forces that define the new investment environment: 1) modern mercantilism, 2) unprecedented portfolio concentration, and 3) a once-in-a-lifetime technological transformation. In today’s report, we explore how inflation fits into this story for investors from a secular perspective. The headline is that the resting heart rate of inflation looks higher than it did pre-pandemic, with 2% more a floor than a ceiling. We expect a structurally wider cone of inflation outcomes, tilted asymmetrically to the upside and centered higher than the 2010s. Going through things a bit more slowly:
- In the 2010s, a uniquely favorable secular backdrop kept a lid on inflation (even when cyclical conditions were running hot). China continued to grow global market share and export extremely low-cost goods to the rest of the world; shale came online; the post-GFC deleveraging and European sovereign debt crisis weighed on consumption; and inflationary pressures from the prior decade rolled off, like the end of the commodity supercycle of the 2000s. The result was an unusual convergence of downward secular forces, which was enough to largely override the effects of upward price pressures in other parts of the consumer basket, such as services and housing.
- Today, many structural dynamics in the new investment environment look inflationary, especially in the US. Across the world, governments are playing an increasingly activist role in the economy. In the US, the independence of the Fed is coming under increased pressure, even though that institutional independence is a bedrock of effective inflation management. President Trump’s tariff and trade policies are rewiring the global trade architecture, tilting the world away from disinflationary globalization to inflationary deglobalization. The potential end of US capital exceptionalism could drive meaningful dollar devaluation and import inflation into the US as well. The way each of these secular dynamics ultimately flows through to inflation varies—some are downward pressures on aggregate supply, others are upward pressures on demand—but the directional pressure is clear.
- AI is the obvious wild card and could prove massively disinflationary. However, assuming that AI will more than offset all the inflationary pressures from this environment is a highly speculative bet that looks undesirable for allocators to make. It is also proving inflationary in the shorter term—already putting clear pressure on electricity prices and driving up demand for the resources and commodities needed to expand power generation and the transmission grid. Longer term, the most disruptive AI scenarios (a productivity miracle, post-scarcity abundance) could clearly drive unprecedented disinflation, but it’s easy to imagine alternative worlds where you get the booming economic conditions and higher returns on capital with a more muted disinflationary result.
- Investors are insufficiently prepared for the risks embedded in this new environment, even though the cost of hedging those risks is low. Most portfolios remain highly concentrated in assets that materially underperform during inflation spikes (stocks and bonds), especially when those spikes require central banks to engineer a tightening of real conditions to bring inflation back under control. They are also heavily geographically concentrated in the US, the economy where we see relatively more structural inflation risks lining up. With inflation protection relatively cheap right now, the risk/reward of tapping into more inflation protection to ensure that investors meet their desired objectives looks strong to us.
In one sense, inflation in the new investment environment is not “new” at all—it’s a return back to baseline (i.e., pre-GFC), where inflation risks are front and center and overheating cyclical conditions can see inflation bounce above target.
At the same time, much is new, and many of those new hallmarks are inflationary. The table below provides a concise summary of the most important secular pressures as we see them.
Another way of highlighting some of the risks facing investors is to home in on the tensions embedded in the current US inflation picture. On the one hand, inflation is benign relative to pandemic-era highs and our systematic estimates expect it to continue falling somewhat. On the other hand, it is still clearly a thorn in the Fed’s side, disinflation has basically stalled out for much of the last 12-18 months, and core has now been running above target (in six-month annualized core terms) for five whole years. The last half-mile is the hardest, and failing to get there can result in sustained inflation accrual that is painful for most portfolios.
The remainder of this report is focused on further exploring the problem: structural inflation vulnerabilities amid a structurally more inflationary macro paradigm. In the past, we have written extensively about some of the ways that allocators can secure better inflation protection; in subsequent reports, we will provide our latest thinking on solutions to this problem, with an eye to unconstrained options available to allocators using a Total Portfolio Approach.
Most Portfolios Remain Highly Vulnerable to Unexpected Inflation, Especially in Real Terms
A core premise of our approach to portfolio engineering is that all assets have environmental biases to growth, inflation, and liquidity, and that these biases determine a given portfolio’s aggregate ex ante exposures to different macro environments. Traditional portfolios are materially exposed to regimes where inflation comes in stronger than discounted—underperforming when that factor is rising in isolation, while experiencing material contraction when inflation also forces central banks to raise rates and tighten liquidity as a result.
The recent pandemic shock viscerally brought this to the forefront for most investors—higher inflation volatility caused the negative correlation that stocks and bonds enjoyed in the 2000s and 2010s to flip, driving abysmal returns and outright drawdowns for 70/30s. Investors learned the painful lesson that the diversifying correlation they had grown used to had been a statistical artifact of the specific macro regime of the previous decade or so, and not a reflection of the immutable properties of the assets themselves. The chart below illustrates this; in the same way that the benign inflation of the late 2000s and 2010s was the exception, not the rule, so too was the negative correlation of stocks and bonds.
Consistent with this, roughly half of the worst drawdowns for traditional 70/30 portfolios since the 1960s have been during inflation spikes that triggered a tightening of liquidity conditions—the 1970s, the 1980s, and the COVID-era inflation spike. Importantly, during such periods, inflation also had the effect of mechanically eroding the real returns facing investors above and beyond the drawdowns they already faced in nominal terms. The late 1970s and early 1980s are an especially stark example—the traditional 70/30 took notably longer to get out of its drawdown in real terms than in nominal terms.
Another way that inflation impacts typical portfolios is that you sometimes see solid nominal performance that is actually extremely poor in real terms under the hood (i.e., accrued inflation has eroded real returns). The below scatter plot illustrates this, charting the annualized nominal returns versus real returns for US 70/30 portfolios for every trailing 10-year interval since 1970. As you can see, inflation accrual means that even moderate-returning decades can yield either middling or outright negative real returns under the hood.
Many Hallmarks of the New Investment Environment Create Clear Upside Risks to Inflation
The state is playing an increasingly activist role in the economy, potentially pushing spending beyond productive limits
We are seeing unprecedented deficits relative to conditions across many developed economies. The US is running a ~7% GDP budget deficit despite the fact we are in a mid-cycle expansion. It’s easy to see how that could easily shoot up several percentage points should conditions weaken, revenues fall, and automatic stabilizers kick in (though to be clear, that is not our base case over the next 12 months). This isn’t just a US phenomenon—we’re seeing similar dynamics in Europe and the UK as well (though not Canada, where the deficit is consistent with pronounced weakness, or Australia, which is benefiting from its status as a major commodity exporter).
This fiscal posture can be inflationary in three main ways: 1) it is a source of additional demand being funneled into economies that don’t need conditions propped up; 2) it risks being spent in particularly inflationary areas/ways; and 3) the borrowing itself can crowd out important private sector activity in a way that is inflationary longer term.
On the second point: in general, the public sector is less price-sensitive than the private sector, especially when its spending is targeted at areas of specific strategic or political interest. The inflationary impulse is clearest when the policy impulse basically boils down to extra nominal spending not attached to more capacity build-out (e.g., social service provisions). Sometimes the pressures are more cross-cutting, as is the case when policy is specifically geared toward building productive capacity. The concerted defense push is a good example here: NATO member states are mobilizing a huge pool of spending in support of a specific strategic object, and one upshot of this is that many will meaningfully build out their defense and manufacturing capabilities. Even if this is disinflationary longer term, the efforts are likely to push up against price constraints in the interim.
Elevated deficit spending relative to conditions also risks crowding out business capital investment, which could be inflationary longer term. It’s the total amount of borrowing in the economy that matters, and when the public sector is borrowing this aggressively, that ratchets up rates and crowds out the private sector. The UK is a useful case study here. It has experienced the worst productivity growth in the developed world over the last few years owing to a combination of 1) the long-term drag from Brexit-induced capex underinvestment, 2) large and growing government spending on social services (e.g., healthcare, entitlement spending), and 3) inflexible labor markets. The capex hangover is only one piece of the story, and it was largely driven by Brexit and not elevated rates, but the UK case nevertheless highlights the risks associated with secular pressures that decrease the private sector’s marginal propensity to drive business fixed investment.
Central bank independence—a foundation of modern inflation management—is increasingly under threat in the US
Over the past few months, Trump has ramped up criticism of the Fed for keeping rates restrictive relative to his preferred policy posture. He has also taken actions to assume greater executive authority and influence over the body, raising questions about its trajectory. Below, we lay out some of Trump’s key quotes and actions, most recently firing Governor Cook over alleged mortgage fraud, a firing that Cook is contesting in the courts.
Central bank independence is a hallmark of modern inflation management. There is a range of outcomes around what happens under less independent central banks, with the main risk being that politicians are more likely to push central banks to ease. But, on balance, that intervention generally increases the odds of an undesirable inflation outcome. At the start, there is often a valid case for easier policy, as we see today (albeit with a small margin for error). Over time, however, political influence generally expresses itself as a downward pressure on rates relative to conditions. This can also weigh on the currency (either because of the lower rates, or because of capital outflows as investors shift to price in higher political risk premiums). Consistent with this, economies with less independent central banks have typically seen higher realized inflation over the long run.
Exactly how things shake out is unclear, and it’s far from our base case that Trump fully takes over the keys of the FOMC, but this is a structurally new inflationary risk facing the US that investors need to keep front and center.
An unprecedented attempt at rewiring the global trade architecture is unfolding in real time
Thus far, modern mercantilism has been a disinflationary pressure basically everywhere outside the US. By triggering a sharp dollar sell-off, it has materially decreased the cost of dollar-denominated commodities in local currency terms outside the US, and by engineering profound hurdles to US/China trade (at times an effective trade embargo, at other times just meaningfully elevated tariffs), it has increased the odds that we will see Chinese goods dumping in non-US markets. Even in the US, we’re mostly reading Trump’s tariff regime as driving more of a one-off price increase rather than creating sustained inflation pressures.
But what matters is not the effects of what’s unfolding right now—it’s the long-term strategic vision that Trump’s 2025 tariff and trade policies are in pursuit of. Trump is trying to engineer a seismic reversal of more than half a century of globalization—a rotation away from lowest marginal-cost production, the global division of labor, and just-in-time supply chains to a world that prioritizes domestic industrial bases and balanced current accounts. It’s not clear how far this rewiring will go, but the cost of things like a US manufacturing renaissance is the higher prices necessary to sustain them and a potential misallocation of capital to get there.
A confluence of secular pressures could weigh on the dollar and import inflation into the US
The potential end of US capital exceptionalism, threats to Fed independence, and lower real rates are all directionally dollar-bearish pressures that are unfolding at a time when the dollar is still relatively expensive in real terms (even accounting for the recent sell-off). As you can see in the chart below, scanning back over the last few decades highlights just how far dollar devaluation can run when it picks up steam. Dollar devaluation cycles have generally been associated with commodity bull runs (true in the 1970s and 2000s, more mixed in the 1980s). Commodities being dollar-denominated means that these cycles are a cheapening of commodities in local currency terms, pushing up demand, but also a hit to the revenues of commodity producers in dollar terms, encouraging them to pull back production and/or delay capex. As we scan ahead, dollar devaluation is likely to exert itself more through commodities than imported goods inflation, as most US trade is invoiced in dollars, but we’d still expect a marginal upward pressure through the goods channel as well.
The recent inflation wave has likely increased the risks associated with future price shocks
The 1970s and 1980s are the canonical proof point that once you’ve let the cat out of the bag, it can be hard to get it back in. After one painful experience, businesses can become more willing and able to pass on factory-gate inflation, and consumers can become more attuned to the impact that inflation has on their real wages. Put differently, one inflation wave can lay the foundations for the second by attuning players in the economy to inflation and rewiring how they respond to price pressures—even ones quite divorced from the initial price shock. That amplifies the risks associated with subsequent shocks and all else equal increases the odds they manifest in wage-price spirals.
The AI Transformation Is the Main Force Pushing the Other Way, but the Extent and Timing Are Unclear
The AI transition is already coming up against supply constraints and creating inflationary pressures. This transformational technology has a physical footprint—AI compute requires a huge amount of electricity and the underlying infrastructure (data centers, transmission grids) to support that energy demand. We’re already seeing the impacts as a result: electricity inflation is outstripping the broader price pressures in the economy; colossal data center capex (much of which is still ahead of us) is flooding nominal spending into the US, helping prop up the expansion; and this capex is pushing up against constrained supply for key input materials.
This wave of AI capex build-out is also putting an upward pressure on key input commodities like copper, silver, and uranium at a time when the supply/demand picture in these markets already looks tight under the digitization push and the energy transition. If AI adds additional incremental demand, these commodities look set to experience significant structural supply deficits and upward price pressure.
The wild card is how much productivity this AI transformation unlocks, how that productivity flows through to conditions, and over what time frame this occurs.
The linkages are relatively clear: productivity improvements will decrease the cost of labor on a productivity-adjusted basis; the automation of work will cool the labor market (to the extent that it erodes aggregate demand for labor and does not simply improve how productive that labor can be); AI will spur cost-saving technological innovations, driving down costs (to the extent that businesses do not simply absorb those savings in their margins); and AI will also spur quality-enhancing innovations, driving down goods inflation on a quality-adjusted basis.
The question is the magnitude. Trying to quantify these dynamics is ultimately highly imprecise, because there is a huge cone of outcomes around where AI settles and the ultimate impact on the structural economic landscape. The question then is what investors ought to do given that cone of outcomes. As stated above, the bet that the disinflationary impact of AI will be more than enough to offset the long list of secular inflation risks is ultimately a speculative one, and one where the risk/reward for allocators does not look attractive.
This research paper is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives, or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This material is for informational and educational purposes only and is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Any such offering will be made pursuant to a definitive offering memorandum. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors which are necessary considerations before making any investment decision. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, where appropriate, seek professional advice, including legal, tax, accounting, investment, or other advice. No discussion with respect to specific companies should be considered a recommendation to purchase or sell any particular investment. The companies discussed should not be taken to represent holdings in any Bridgewater strategy. It should not be assumed that any of the companies discussed were or will be profitable, or that recommendations made in the future will be profitable.
The information provided herein is not intended to provide a sufficient basis on which to make an investment decision and investment decisions should not be based on simulated, hypothetical, or illustrative information that have inherent limitations. Unlike an actual performance record simulated or hypothetical results do not represent actual trading or the actual costs of management and may have under or overcompensated for the impact of certain market risk factors. Bridgewater makes no representation that any account will or is likely to achieve returns similar to those shown. The price and value of the investments referred to in this research and the income therefrom may fluctuate. Every investment involves risk and in volatile or uncertain market conditions, significant variations in the value or return on that investment may occur. Investments in hedge funds are complex, speculative and carry a high degree of risk, including the risk of a complete loss of an investor’s entire investment. Past performance is not a guide to future performance, future returns are not guaranteed, and a complete loss of original capital may occur. Certain transactions, including those involving leverage, futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Fluctuations in exchange rates could have material adverse effects on the value or price of, or income derived from, certain investments.
Where shown, the All Weather Lens is an analytical approach to assess the behavior of the major drivers of asset performance and their impact on markets during any given period, based on Bridgewater’s understanding of global financial markets. Information shown is the result of analyses of actual and simulated market data.
Bridgewater research utilizes data and information from public, private, and internal sources, including data from actual Bridgewater trades. Sources include BCA, Bloomberg Finance L.P., Bond Radar, Candeal, CEIC Data Company Ltd., Ceras Analytics, China Bull Research, Clarus Financial Technology, CLS Processing Solutions, Conference Board of Canada, Consensus Economics Inc., DTCC Data Repository, Ecoanalitica, Empirical Research Partners, Energy Aspects Corp, Entis (Axioma Qontigo Simcorp), Enverus, EPFR Global, Eurasia Group, Evercore ISI, FactSet Research Systems, Fastmarkets Global Limited, The Financial Times Limited, Finaeon, Inc., FINRA, GaveKal Research Ltd., GlobalSource Partners, Harvard Business Review, Haver Analytics, Inc., Institutional Shareholder Services (ISS), The Investment Funds Institute of Canada, ICE Derived Data (UK), Investment Company Institute, International Institute of Finance, JP Morgan, JTSA Advisors, LSEG Data and Analytics, MarketAxess, Metals Focus Ltd, MSCI, Inc., National Bureau of Economic Research, Neudata, Organisation for Economic Cooperation and Development, Pensions & Investments Research Center, Pitchbook, Political Alpha, Renaissance Capital Research, Rhodium Group, RP Data, Rubinson Research, Rystad Energy, S&P Global Market Intelligence, Sentix GmbH, SGH Macro, Shanghai Metals Market, Smart Insider Ltd., Sustainalytics, Swaps Monitor, Tradeweb, United Nations, US Department of Commerce, Visible Alpha, Wells Bay, Wind Financial Information LLC, With Intelligence, Wood Mackenzie Limited, World Bureau of Metal Statistics, World Economic Forum, and YieldBook. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy. Data leveraged from third-party providers, related to financial and non-financial characteristics, may not be accurate or complete. The data and factors that Bridgewater considers within its research process may change over time.
This information is not directed at or intended for distribution to or use by any person or entity located in any jurisdiction where such distribution, publication, availability, or use would be contrary to applicable law or regulation, or which would subject Bridgewater to any registration or licensing requirements within such jurisdiction. No part of this material may be (i) copied, photocopied, or duplicated in any form by any means or (ii) redistributed without the prior written consent of Bridgewater® Associates, LP.
The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.