Investing Across a New Inflation Regime

Foreword

By Stephen D King, HSBC Senior Economic Adviser, Author of We Need to Talk About Inflation (Yale University Press, 2023)

Inflation’s Return and a Regime Shift in Rates

Inflation has returned. Many thought it was an economic problem buried in history books. No longer. Since the onset of Covid, central banks have struggled to bring inflation to heel. For many years, and particularly after the 2008 Global Financial Crisis - inflation was too low. Policymakers feared that Japan’s deflationary malaise, a world in which prices were falling, would spread elsewhere. That narrative is no longer relevant. Since 2021, inflation in the developed world has been either at or above target. The cost of keeping inflation under control has risen. Central bank policy rates are much higher than they once were. The bull market in bonds, which dragged long term interest rates lower from the early-1980s onwards, has abruptly reversed.

Temporary Shocks vs Deeper-Rooted Inflation Drivers

Some would argue that recent inflationary troubles are merely temporary in nature, a consequence of a series of unfortunate events. Covid led to supply shortages. Russia’s invasion of Ukraine temporarily lifted natural gas prices. The Iran War closed the Strait of Hormuz and led to higher and more volatile oil prices. All of this is true. Yet the persistence of inflationary overshoots may also reflect other, more deep-rooted, drivers. In the early stages of the Covid pandemic, central banks offered huge amounts of monetary support. For them, the primary macroeconomic challenge was a shortfall in demand, not supply. When inflation first began to rise, it was, apparently, a transitory phenomenon. That language was eventually abandoned. Central banks finally raised interest rates. By that stage, however, the public had figured that their monetary masters were not omniscient after all. If central banks could make mistakes, maybe inflation wasn’t dead and buried.

Debt, Fiscal Strain and the Temptation to Inflate

At the same time, many began to fret about seemingly relentless increases in government debt. In the UK, where data extends back hundreds of years, it’s safe to say that, in peacetime, we have never before witnessed such huge gains. Budgetary authorities, including the CBO in the US and the OBR in the UK, project further massive increases in coming decades. Slow growth (and, hence, slow revenue growth), population ageing (adding to pension and healthcare spending), heightened defence spending and higher debt service costs threaten to deliver persistently large budget deficits year after year.

Achieving fiscal stability under these circumstances is a huge political challenge. If taxes are already high and spending cuts are politically unachievable, the remaining options are both limited and fraught with risk. Indulge in financial repression, rigging capital markets to allow government to jump to the front of the credit queue. Default. Devalue. Or, in time honoured fashion, inflate. From the Ancient Romans through to Revolutionary France, and from the Confederacy during the American Civil War through to 1970s Britain and its IMF bailout, desperate leaderships have too often turned to the printing press. Unanticipated inflation always rewards the debtor at the expense of the creditor.

Perhaps this time will be different. Elon Musk talks about an AI-inspired age of abundance, in which prices are more likely to fall than rise. Unlike much of the developed world, China is suffering deflation (it’s no coincidence that its central bank did not loosen monetary policy to match the Federal Reserve, the European Central Bank and others in the early stages of the Covid crisis). Nevertheless, once established, inflation is a mightily difficult beast to slay. A central banker once defined “price stability” as a situation in which no one is talking about inflation. On that definition, we’re still a long way from home.

Macroeconomic Environment

Is inflation targeting under threat?

Summary

• US post-war inflation can be read through three distinct regimes: high/volatile (1960s to the early 1980s), disinflation (Volcker onwards), and a long low/stable period (mid‑1990s – 2020)
• Since the pandemic, that stability has broken: US PCE* inflation has averaged around 4.0 per cent since 2021, versus a 1.8 per cent average over the prior 25 years
• Base case isn’t a return to 1970s-style inflation, but it may be a world of greater volatility, where 2 per cent behaves more like a floor than a ceiling

US post-war inflation can be framed as three regimes: high and volatile inflation from the 1960s to early 1980s when inflation control wasn’t prioritised; disinflation from the Volcker era onwards; and a long period of stable, low inflation from the mid‑1990s to 2020 as the Federal Reserve adopted de facto inflation targeting (implicit from the mid‑1990s and explicit from 2012). Over that c. 25-year span prior to the pandemic, US PCE inflation averaged 1.8 per cent.

Since the pandemic, that performance has deteriorated. US PCE inflation has averaged around 4.0 per cent since 2021, around double the Fed’s 2 per cent objective, and has risen again following an oil price shock. The key question is whether this marks a shift to a structurally higher inflation regime.

The base case is not a return to pre‑1990s inflation, but a world of greater inflation volatility, with 2 per cent acting more like a floor than a ceiling compared with the 2010s. Three forces could make inflation pressures more persistent this decade: more frequent supply shocks (deglobalisation, geopolitics, climate impacts), ageing-driven labour supply constraints (especially if immigration is restricted), and fiscal strain with already-high debt and rising entitlement spending pressures (social security and pensions).

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The central thesis is that inflation is a choice: shocks can’t be prevented, but credible and willing policymakers can keep average inflation low. Upside risks include a gradual ratchet up in expectations caused by more frequent supply-side shocks and, less likely but more disruptive, fiscal dominance leading to a change in the inflation-targeting framework.

*PCE - Personal consumption expenditures price index.

Multi-Asset

Equity-Bond diversification is challenged in higher inflation regimes

Summary

• Broaden diversification: As equity/bond diversification becomes less reliable in higher inflation, consider complementing traditional allocations with real assets, commodities and liquid alternatives
• Be selective in fixed income: Manage duration risk carefully and, where appropriate, consider shorter-dated inflation-linked bonds for more effective protection when rates are rising
• Prioritise resilience: Focus on risk-adjusted returns and build portfolios designed to hold up across a range of inflation outcomes, rather than relying on one “base case” scenario

Higher Inflation Weakens Equity-Bond Diversification

From a multi-asset perspective persistent inflation and higher interest rates require investors to rethink how portfolios are constructed. One of the biggest challenges in a higher inflation regime is the weakening of the traditional diversification benefits between equities and bonds. As inflation rises, the correlation between these asset classes tends to increase, reducing the effectiveness of the classic balanced portfolio, while overall market volatility also rises, particularly during stagflationary environments.

Historical equity bond correlation in regimes since 1960

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When looking at market returns, equities and conventional fixed income can face headwinds in real terms when inflation remains elevated. In contrast, assets linked more closely to the real economy, such as listed infrastructure, property and commodities, have historically demonstrated greater resilience, benefiting from inflation-linked revenues, pricing power or direct exposure to rising commodity prices. Inflation-linked bonds can also play an important role, although investors should remain mindful of duration risk, with shorter-dated inflation-linked exposure often offering more effective protection when interest rates are rising. Finally, liquid alternative strategies, such as trend-following approaches, can provide diversification through different market regimes by relying less on traditional equity and bond market relationships.

European Equities

Pricing Power Over Hope: Winning in an Inflation Regime

Summary

• Inflation isn’t a blanket equity hedge: Real returns can disappoint as higher costs and valuation pressure (rates/risk premia) offset nominal earnings growth, so sector and stock selection matters most
• Back pricing power and quality: Prioritise companies that can pass through costs and protect margins, delivering resilient cash flows and sustainable returns on capital
• Stay disciplined on price and income: Favour attractively valued names and reliable dividend growers, which may be better positioned as discount rates and equity risk premia remain elevated

Pricing Power, Margins and Valuations

The widely held assumption that equities automatically provide an effective hedge against inflation comes with mixed evidence. While company revenues and dividends may rise in nominal terms as prices increase, history suggests that periods of sustained inflation have not necessarily translated into strong real equity returns. Looking back to the high inflation environment of the 1970s, although nominal earnings growth remained relatively resilient, much of this was offset by higher costs and margin compression, leaving real earnings growth close to zero.

Equity returns are driven by three key factors: earnings growth, dividend income and changes in the equity risk premium. Persistent inflation can affect each of these differently. Companies with limited pricing power may struggle to pass higher input costs on to customers, resulting in lower margins and weaker returns on capital. At the same time, higher interest rates increase the attractiveness of risk-free assets, placing pressure on equity valuations as investors demand higher dividend yields and a greater equity risk premium to compensate for increased uncertainty.

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Not all sectors are affected equally. Businesses positioned earlier in the supply chain, including industrial and commodity-related companies, have historically been better able to preserve profitability, while more consumer-facing sectors have often experienced greater margin pressure. More recently, sectors such as European banks have benefited from higher interest rates through improved net interest margins, illustrating how inflationary environments can create both winners and losers.

The key to investing successfully in a higher inflation regime lies not in treating equities as a broad inflation hedge, but in identifying companies with durable pricing power, resilient profitability and attractive valuations. In an environment where inflation uncertainty remains elevated, businesses capable of sustaining margins, generating reliable cash flows and paying competitive dividends are likely to be better positioned than the broader market.

Global Equities

Pricing Power: The Inflation Shield for Margins

Summary

• Quality: Prioritise pricing power, companies with durable competitive advantages that can defend margins as costs rise
• Dynamism: Favour strong management teams and businesses with operational flexibility to adapt pricing, products and cost bases as inflation conditions change
• Robustness: Look beyond headline revenue/earnings uplift and focus on free cash flow durability, returns on capital, and the ability to grow dividends in real terms over time

Pricing Power and Quality: Protecting Margins in Inflation

Looking at the inflation challenge from a bottom-up perspective, the key investment question is not whether inflation lifts company revenues, but whether businesses can continue to generate attractive returns when costs rise persistently. Working with the themes of earnings quality, valuation discipline and sustainable income, the defining characteristic of a resilient business is pricing power, the ability to protect margins by passing higher costs on to customers without damaging demand. This pricing power can arise from a number of competitive advantages, including strong brands and market share, intellectual property, a favourable position within the value chain, or significant purchasing power over suppliers. Together, these characteristics help companies maintain returns on capital and generate consistent cash flows despite inflationary pressures.

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Source: HSBC Asset Management, Bloomberg, June 2026.

However, pricing power alone is not enough. It is important for management quality and the strategic flexibility to respond to changing cost environments. Companies that can optimise their cost base, redesign products, adjust pricing structures or use temporary cost absorption to strengthen competitive positioning are often better placed to preserve profitability over the long term. Rather than assuming inflation will naturally translate into higher earnings, the emphasis should be on identifying businesses capable of sustaining margins and free cash flow through multiple economic cycles.

For long-term investors, resilience comes from owning companies with durable competitive advantages and disciplined capital allocation. These are the businesses most likely to continue growing earnings and dividends in real terms, regardless of the inflation backdrop.

Inflation-Linked Bonds

Real Return Defence: The Role of Linkers

Summary

• Protect purchasing power: Use inflation-linked bonds alongside conventional government bonds to help preserve real wealth when inflation remains elevated, as coupons and principal adjust with inflation
• Watch breakevens (with nuance): Monitor breakeven inflation as a timely gauge of market inflation expectations; while recognising it also embeds risk premia and liquidity effects (so it isn’t a pure forecast)
• Deploy by regime: Position inflation-linked bonds strategically, they tend to outperform when inflation expectations rise or inflation surprises to the upside but can lag nominal government bonds in recessions/deflationary shocks when inflation expectations fall

Protecting Real Returns

Inflation-linked bonds can play an important role in helping investors preserve purchasing power when inflation remains elevated. Unlike conventional government bonds, where coupons and principal are fixed in nominal terms, inflation-linked bonds adjust both their coupon payments and principal value in line with inflation. As a result, they are designed to deliver a real return, making them a valuable tool for managing inflation risk within fixed income portfolios.

A key concept in understanding the asset class is the breakeven inflation rate, the difference in yield between a conventional government bond and an equivalent inflation-linked bond. This represents the average rate of inflation at which an investor would be indifferent between holding the two securities. While breakeven rates provide a useful real-time measure of market inflation expectations, they are not a pure forecast, as they also reflect factors such as investor risk premia and market liquidity.

Looking at the post-pandemic inflation surge, inflation-linked bonds can outperform conventional government bonds when inflation expectations rise, as widening breakeven inflation rates help cushion the impact of rising yields. However, their relative performance depends on the broader macroeconomic environment. Inflation-linked bonds have historically performed best during periods of elevated inflation or stronger nominal growth, while conventional government bonds have tended to outperform during recessions or deflationary shocks, when inflation expectations decline.

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Sources: HSBC Asset Management and Bloomberg as of February 2026. (*)Personal Consumption Expenditures Price Index, Excluding Food and Energy. The views expressed above were held at the time of preparation and are subject to change without notice.

With the global inflation-linked bond market now exceeding several trillion dollars and spanning both developed and emerging markets, the asset class has become an increasingly important component of the fixed income universe, offering investors a practical way to diversify nominal bond exposure and improve portfolio resilience in an uncertain inflation environment.

Securitised Credit

Asset Allocation benefits of adding Securitised Credit

Summary

• Income support in higher for longer: Securitised credit can enhance portfolio income via floating-rate coupons (often linked to SOFR/SONIA), meaning cashflows may rise as policy rates stay elevated
• Diversification within fixed income: Returns are driven more by underlying collateral performance and structure than by traditional duration or corporate fundamentals, adding a differentiated source of risk/return alongside government and corporate bonds
• Targeted risk with relative value opportunities: The tranche structure allows investors to focus on senior, credit-enhanced positions, while a global opportunity set can help capture valuation and rate differences across regions

Floating-Rate Income and Diversification

Securitised credit can play a meaningful role within fixed income portfolios in a higher-for-longer interest rate environment, acting as a complementary source of both income and diversification. Unlike traditional corporate bonds, it is backed by pools of underlying assets, such as residential and commercial mortgages, structured into tradable securities with different risk/return profiles. A key attraction is the combination of floating-rate income and relatively attractive credit spreads: many securitised instruments pay coupons linked to reference rates such as SOFR or SONIA, meaning income can increase as policy rates remain elevated, while spreads in several securitised sectors still compare favourably with similarly rated corporate credit.

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The asset class can also diversify more traditional government and corporate bond exposure, with performance driven by collateral fundamentals and structural protections rather than purely by duration or corporate balance sheets. Importantly, the tranche-based structure allows investors to target senior positions with substantial credit enhancement, which can help limit downside risk if economic conditions deteriorate. With collateral often tied to real assets (including property), there may also be some additional support for credit quality in an inflationary backdrop. Finally, a global approach can help investors capture differences in regional rates and valuations, though disciplined security selection and an emphasis on senior tranches remain important, particularly if inflation becomes more extreme. As illustrated in the chart, increasing the allocation to investment grade securitised credit (funded from global aggregate bonds) is associated with higher annualised returns alongside slightly lower volatility in the portfolio mix shown.

Listed Real Assets

Inflation Pass-Through Meets Rate Reality

Summary

• Prioritise inflation pass-through: Focus on listed infrastructure/real estate businesses with clear mechanisms to pass inflation through to end users (e.g., regulated tariffs, rent indexation, contractual price escalators), as this is the key driver of purchasing-power protection
• Balance cashflow uplift vs rate pressure: Treat listed real assets as long-duration exposures, higher inflation can lift cash flows, but rising discount rates can still compress valuations, so outcomes depend on the net of these two forces
• Be selective (especially across sub-sectors): Listed infrastructure has historically been more resilient than listed real estate in higher-inflation regimes due to more effective contractual/regulatory pass-through; active management and security selection matter because regulation, contract terms and business models drive wide dispersion

Inflation Pass-Through and Rate Sensitivity

Listed infrastructure and listed real estate can both contribute to portfolio resilience in a higher-for-longer inflation environment, but they shouldn’t be viewed as a homogeneous “real assets” allocation. Their ability to preserve purchasing power depends largely on one critical characteristic: the ability to pass higher inflation through to customers via mechanisms such as rent increases, regulated tariffs or contractual price escalators.

However, inflation protection is only one side of the equation. Listed real assets are also long-duration investments, with valuations based on cash flows expected many years into the future. As inflation pushes interest rates higher, rising discount rates can place downward pressure on valuations, meaning performance reflects a balance between stronger cash flows from inflation pass-through and weaker valuations resulting from higher rates.

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Looking across different inflation regimes since the early 2000s, listed infrastructure has generally demonstrated greater resilience than listed real estate during periods of elevated inflation, largely because contractual or regulated revenue frameworks allow inflation to be passed through more effectively and help offset the impact of rising rates. By contrast, listed real estate has historically performed best in environments of low and falling inflation, when declining interest rates support valuations. A key conclusion is that successful investing requires looking beyond broad labels, regulatory frameworks, contract structures, competitive dynamics and the duration profile of individual assets can materially influence performance, so active management and detailed security selection are important.

Inflation Resilience: Themes and Trade-offs

Building Inflation Aware Portfolios

Summary

• Real assets matter: Over the long run, real estate and energy equities have the most repeatable, evidence-backed resilience in inflationary periods, though outcomes depend on market and country exposure
• Factors beat forecasts: Inflationary episodes coupled with rising rates favours value stocks over long-duration growth stocks; the 2022 episode was a clear recent example, with value outperforming growth by around four times (in 2022). Quality and high dividend yield stocks tend to be resilient, while momentum stocks showed mixed results
• Defensive sectors help preserve capital: Consumer staples and utilities tend to combine pricing power with more defensive characteristics as purchasing power erodes. Defensive sectors can help to mitigate drawdown risk during inflationary episodes

Why Inflation Positioning is More Nuanced This Time

Despite inflation risk rising again across the US and Europe few investors have positioned for a more secular pickup in inflation still viewing it as a transitory phenomenon. In practice, there isn’t one perfect asset allocation construct that works in every inflationary regime, and outcomes are often driven by the source of the inflation and the policy response. 2022 is the cleanest reminder: inflation and aggressive rate hikes hit at the same time, and both equities and bonds sold off, making “simple” inflation playbooks less reliable and diversification harder to find.

Against that backdrop, we think it’s helpful to frame inflation resilience through practical themes that investors can use when considering portfolio allocations that have worked across inflationary regimes.

Real Assets remain the most traditional and evidence-backed hedge. Real estate, infrastructure and energy equities have historically offered the most consistent resilience when inflation runs hot, although real estate as an asset class can react in a more nuanced fashion depending on inflationary regime.

Inflationary periods often come with higher rates, and that tends to shift leadership within equities towards value. The post-Covid inflationary boom of 2022 provides the cleanest recent illustration of this dynamic, with growth materially lagging and value outperforming by close to four times. However, results can look different across regions as momentum and quality performed well in certain markets such as Japan and EM equities.

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Points to consider for an inflation aware allocation:

• Global Real Estate ETFs can provide geographical diversification—particularly important in today’s environment, where inflation trends and rate hike trajectories vary by region
• Factor ETFs can provide direct exposure to specific factors. Investors may prefer a broad, global value approach or opt for region-/country-specific factor allocations
• Sectoral diversity in the portfolio: Investors can choose to take outright sector bets or build a more sector-diversified portfolio by allocating to markets with different sector compositions (for instance, the FTSE 100 is weighted towards traditional industries such as financials and energy compared to the S&P 500)

Defensive Positioning for Inflation Drawdowns

While inflation can reward the right exposures, it can also increase the risk of drawdowns through volatility, margin pressures, and shifting policy expectations. In that context, defensive and quality exposures can play a useful role as a source of capital preservation.

Sector positioning matters. As purchasing power erodes, consumers typically trim non-essential spending first, which is why utilities and consumer staples are often favoured over discretionary sectors in inflation-aware portfolios. These sectors tend to combine steadier demand with the potential for pricing power, offering a more defensive profile when inflation is persistent.

Emerging market dynamics: Whilst we have seen classic value plays provide encouragement in developed markets, we note that quality is the most consistent stabiliser across regimes in EM, momentum is a structural risk here as it tends to lead in good times and lag in bad times suggesting a quality led exposure could be a useful downside stabiliser.

An inflation-aware equity sleeve can be framed around three building blocks: targeted exposure to real assets (notably real estate and energy), a tilt towards value, and an allocation to defensive sectors such as utilities and consumer staples, complemented where appropriate by a focus on quality to help manage drawdown risk.

Source: HSBC Asset Management, data as of July 2026.
Past performance does not predict future returns. The views expressed above were held at the time of preparation and are subject to change without notice. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecast, projection or target. Diversification does not ensure a profit or protect against loss. This information shouldn’t be considered as an investment advice.