Inflation is one of the biggest puzzles bedevilling financial markets right now. It’s rising, but central banks maintain that it’s transitory, and so they’re resisting raising interest rates to keep prices rises under control.

This is a conundrum for individual investors trying to work out how to protect their portfolios against rising prices and maintain some balance in their allocation to different sectors and assets.

PANDEMIC HAS DRIVEN INFLATION

Inflationary risks have definitely become elevated since the pandemic hit, because of all the fiscal and monetary stimulus that’s been thrown at the economy, but there are also some reasons to believe that the Bank of England may be right in its forecast that inflation will remain contained.

The oil price, for instance, is a key component of inflation. Oil is currently trading at around $75 a barrel, which compares to the $20 a barrel it slumped to in the immediate aftermath of global lockdowns last year.

Clearly such a big rise in the oil price since then has a massive knock-on effect on the headline inflation figure, which compares prices today with prices a year ago. But to keep having a similar effect on inflation in the coming 12 months, we would need to see a similarly dramatic price rise between now and then.

That seems unlikely, because while economic activity will hopefully kick on from here, it’s going to be very difficult to beat the jump from a locked down economy to an open one.

The same principle applies to wage growth. Latest figures from the Office for National Statistics show that in the year to May, headline wage growth was 6.6%, which is a worrying signal for inflation. Again, the pandemic has warped the figures though, which make it difficult to get a glimpse of the true picture.

WHAT IS THE GOVERNMENT DOING?

We should also be mindful of fiscal policy. The Government really has thrown the kitchen sink at the pandemic and continues to do so. In the March budget, the chancellor announced £24 billion of fiscal giveaways for this financial year, mainly in the form of support for businesses and consumers. That could well stoke inflationary pressures. But the hand that giveth will eventually taketh away.

From 2023 onwards, predominantly through the freezing of tax allowances and raising the rate of corporation tax, the chancellor will start pulling money back in to balance the books. By 2025/26 they will be clawing back £29 billion, simply as a result of decisions made in this year’s budget. By taking that money out of the pocket of consumers and businesses, the chancellor will also be putting the brake on spending, and thereby inflation.

We certainly shouldn’t downplay the inflationary risks faced by the global economy right now – they are very real. But the arguments between inflation being contained and out of control are finely balanced.

HOW DOES IT AFFECT PORTFOLIOS?

That’s not necessarily the case for investor portfolios though. The low interest rate environment we’ve seen in the past decade or so has led to a ballooning in the value of assets that perform well in a low inflation environment, and conversely might struggle if inflation takes off.

Chief amongst these are long dated government bonds, and also investments that can act as bond proxies, such as reliable blue chip companies like Unilever (ULVR) and Reckitt Benckiser (RB.).

The benign inflationary environment has also created the perfect conditions for growth stocks, particularly in the tech sector, where the appeal of foregoing profits today in favour of profits tomorrow is not heavily eroded by high rates of inflation while you wait.

These investments may well still warrant a place in pensions and ISAs, but their strong performance means they may now make up an outsized proportion of portfolios, which potentially leaves investors at risk from an inflationary shock.

Some reallocation of profits may therefore be in order. The evidence both for and against inflation is finely balanced, and that suggests investor portfolios should be too.

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