The phrase “hope springs eternal” was coined in the 18th century by the poet Alexander Pope, but it is a sentiment found on vivid display in today’s inflation debate. As Exhibit 1 illustrates, despite economists thus far consistently and wrongly forecasting a speedy normalization of inflation, the market is nevertheless still pricing a decade ahead characterized by low and stable inflation. We question that view.

Economists have been consistently wrong in forecasting inflation

Markets continue to price in low and stable inflation in coming years

At June 30, 2023. Source: Bloomberg, Refinitiv Datastream, U.S. Bureau of Labor Statistics, OECD, Cohen & Steers analysis.
There is no guarantee that any market forecast set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.
US Inflation measured by the year-over-year change in the U.S. Consumer Price Index (CPI) for all urban consumers. Sell-side economists’ consensus inflation forecasts using Bloomberg consensus (ECFC page).

Of course, the kind of “Goldilocks” scenario consistent with this view—which reflects an environment of moderate economic growth and reliably-balanced supply and demand dynamics—is a possible outcome. However, what is perhaps more surprising is that such sanguine expectations persist despite various measures of U.S. core inflation largely trending sideways in the 4–5% range in recent years, well above both the central bank target and the inflation rates experienced during the pre-pandemic decade.

Furthermore, this trend is mirrored across a number of major economies, including the Eurozone and the UK, where inflation has arguably morphed into an even more severe challenge (Exhibit 2).

Key measures of core inflation have shown few signs of normalization

At June 30, 2023. Source: Bloomberg.
There is no guarantee that any market forecast set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.
(a) Core inflation for the U.S. measured by Supercore PCE (core services PCE less housing) as of April 30, 2023; U.K. measured by CPI excluding energy, food, alcohol and tobacco as of April 30, 2023; Eurozone reflects MUICP excluding energy, food alcohol and tobacco as of April 30, 2023.

As we take a deeper dive into the drivers of today’s inflation difficulties, we believe there are good reasons to question the prevailing consensus that a return to the “old normal” is just around the corner. One primary reason why we maintain a cautious view relates to tight labor markets and associated strength in wage growth.

In our view, we’ve witnessed an adverse supply shock in the labor market, resulting in pervasive mismatches between supply and demand for labor across many major economies. This reduced supply of available and qualified workers has further improved worker bargaining power and increased wage pressures more broadly. Significant wage increases not offset by corresponding increases in productivity generally incentivize businesses to raise prices in an effort to pass along those increased costs to their customers, thereby protecting profit margins. As a result, the overall price level in the economy increases along with increases in input costs, and consumers experience cost-push inflation.

One risk of cost-push inflation is that it can create a cycle of rising prices and wages, as price increases lead workers to demand yet higher wages to maintain their purchasing power. This feeds back into even higher production costs, perpetuating a “wage-price spiral” phenomenon. Indeed, as Exhibit 3 highlights, most major developed economies are currently experiencing at- or near-record low unemployment, with wage growth running significantly ahead of what was seen during the pre-pandemic decade, facts consistent with the threat of a nascent wage-price spiral.

Record low unemployment in developed economies indicates very tight labor markets, while…

…sticky wage growth continues to threaten wage-price spiral risks

At June 30, 2023. Source: Bloomberg.
There is no guarantee that any market forecast set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.
Unemployment rates as of April 30, 2023. Wage growth U.S. and U.K. as of April 30, 2023. Eurozone as of March 31, 2023.
Unemployment reflects the number of unemployed persons as a percentage of the labor force. U.S. wage growth reflects the Atlanta Fed’s Wage Growth Median Tracker, a measure of nominal wage growth of individuals. U.K. wage growth reflects the total weekly remuneration paid to employees in return for work. It excludes the payment of bonuses. Eurozone wage growth reflects the Eurostat labor cost wages and salaries in the Euro Area.

Whether or not an overheated labor market proves to be a source of persistent inflation ultimately hinges on the sustainability of workers’ bargaining power in setting wages. Interestingly, in a recently released academic paper, former Fed Chairman Ben Bernanke and former chief economist at the International Monetary Fund Olivier Blanchard, showcased a model that supports the idea that worker bargaining power could prove to be a serious challenge to inflation containment going forward.

They point to elevation in the vacancy-to-unemployment (V/U) ratio, a measure of labor market slack comparing the number of jobs available relative to the number of people looking for work, as evidence of labor market overheating and, by extension, a key driver of wage growth (see gray box below for further detail on the V/U ratio). The V/U ratio currently stands at 1.8—near record highs—indicating scarcity of labor relative to demand (Exhibit 4).

Recent work by Bernanke-Blanchard points to importance of the vacancies- to-unemployed workers (V/U) ratio as a key determinant of inflation

At June 30, 2023. Source: Bureau of Labor Statistics and FRED.
There is no guarantee that any market forecast or investment objective set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.

In the Bernanke-Blanchard view, current labor market pressures are inconsistent with moderating wage growth. They caution instead that “over time a very tight labor market has begun to exert increasing pressure on inflation, pressure which our model predicts will grow over time.”(1)

The current labor market is experiencing a scarcity of available workers, creating conditions for sustainable upward pressure on wages. This, in turn, has the potential to contribute to higher inflation rates, increased uncertainty in inflation expectations, and the emergence of risks associated with a wage-price spiral. In our view, we could very well see inflation problems staying with us for longer than many currently believe.

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History suggests that once inflation problems have taken root, they’ve remained a stubborn, recurring issue, even if initial containment is achieved. Exhibit 5 compares the path of post-Covid era inflation with the evolution of two major inflationary eras that plagued the U.S. in the 20th century, both of which were characterized by periodic bouts of shortages, price controls, and rationing of essential items.

Two historical periods of recurring inflation problems (post WWII and the 1970s) highlight the difficulty in managing inflation even after initial containment

At June 30, 2023. Source: Bloomberg
There is no guarantee that any market forecast or investment objective set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.
(1) Ben Bernanke and Olivier Blanchard (2023). “What Caused the U.S. Pandemic Era Inflation?” Presented at the Hutchins Center on Fiscal & Monetary Policy at Brookings conference “The Fed: Lessons learned from the past three years”

Notably, inflation challenges in both eras exhibited pronounced cyclicality— inflation rates tended to accelerate, eventually appear to normalize, but then succumb to acceleration once again. Much of these cyclical dynamics can be traced to policy responses, both fiscal and monetary, intended to counter the negative growth impulses stemming from supply-side difficulties. The net result of those efforts, however, tended to be expansion of the money supply and consequent knock-on inflationary pressures. Looking ahead, we believe it’s important for investors to consider the risk that history once again repeats itself.

While supply-side problems in the labor market present the clearest risk to inflation containment today, as we consider the next 5-10 years, we see a host of related concerns developing across the global economy. In our analysis, the prospect of further negative supply-side shocks—which both unexpectedly reduce growth and push inflation higher—is increasing the risk that we could face a regime of “secular stagflation” in the years ahead.

In addition to wage-price pressures, our list of concerns includes rising geopolitical tensions and disrupted supply chains leading to increased deglobalization and “friend-shoring” (trading with countries that adhere to similar economic and business practices/values). Friend-shoring encourages trade partner selectivity over outright trading with the lowest-cost producer, which implicitly limits supply of low-cost goods, services, and labor, increasing the risk of both higher inflation and lower potential growth.

Likewise, heightened geopolitical polarization has increased intra-country political and policy uncertainty and elevated the risk of geopolitical upheaval across certain developed and emerging countries (e.g., Russia, Ukraine, China, E.U., U.S., Iran, North Korea). Ongoing disruptions in essential goods and services may lead to unpredictable price moves, shortages, and unexpected inflation.

These risks are accentuated by fiscal obligations having reached near- historical levels across most major economies in the wake of both the Great Financial Crisis (GFC) and Covid. Political pressure on governments to further stimulate against the backdrop of already burdensome debts creates incentives for financial repression, driving up investor skepticism of fiscal and monetary policy stability and potentially contributing to inflationary pressures over time.

A perhaps more concrete catalyst in the coming years relates to widespread commodity underinvestment and a building “era of scarcity” across the commodity complex (Exhibit 6). In recent years, the supply of commodities broadly has become constrained due to numerous forces, including political and regulatory forces, capital constraints, and management discipline demanded by investors. Reduced commodity supply can be a primary source of cost-push inflation, and as the cost of production rises with higher interest rates, this may further exacerbate upside inflationary pressures.

Ultimately, even if one’s base case is that the stagflationary risks will not come to bear, we believe the risk case alone is worth investors seriously considering how their portfolios might be affected by any number of unexpected future inflation shocks.

‘Era of scarcity’ characterized by low inventories of many key commodities

At June 30, 2023. Source: BMO, CRU, Wood Mackenzie, USDA, IEA, World Gold Council, S&P Global Platts, GFMS, Bank of America, UBS, and Cohen & Steers.
This chart is for illustrative purposes only and does not reflect information about any fund or account managed or serviced by Cohen & Steers. There is no guarantee that any historical trend noted above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. The views and opinions are as of the date of publication and are subject to change without notice. There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific commodities is not a recommendation or solicitation to buy, sell or hold a particular security and should not be relied upon as investment advice.
Z-Score is measured in terms of standard deviations from the mean. If a Z-score is 0, it indicates that the data point’s score is identical to the mean score. A Z-Score of 1.0 would indicate a value that is one standard deviation from the mean. Under a normal distribution, 99.7% of all possible data points are captured within a three standard deviation range. As noted in the charts above, many commodities have Demand-Adjusted Inventories and/or Index Contract 1-12 Spreads which are multiple standard deviations away from their means, as represented by their Z-Scores.

At its core, our case for a diversified allocation to real assets is primarily a direct outgrowth of our long-term, strategic research into the asset class. Our work suggests that maintaining a permanent, full-cycle allocation to real assets creates unique benefits for the broader portfolio, namely the potential to maintain expected returns while reducing overall volatility. This increases risk-adjusted returns—while gaining exposure to assets with a tendency to outperform during bouts of unexpected inflation, which often weigh on core stock and bond returns. We believe attempts to tactically time investments in real assets based on inflation forecasts, whether over the short- or long-term, is more likely than not a fool’s errand. Inflation shocks have historically taken the toll they have precisely because investors and markets have failed to anticipate them.

That said, in light of the risks we’ve outlined here, it is fair to ask how real assets have performed during prior stagflationary periods – years when negative supply-side shocks both unexpectedly reduced growth and pushed inflation higher.

Exhibit 7 documents the central tendency of inflation-adjusted, real returns during such periods. What we find is that commodities and natural resource equities have tended to perform best among real assets, while infrastructure and real estate have lagged. Most striking, though, in our view, is the performance gap between a diversified real assets blend and stocks and bonds. As it turns out, stagflationary environments may be times when real assets deliver some of their most valuable benefits.

Relative real return by category vs. long-term average in stagflationary (1991-2023)

At June 30, 2023. Source: Cohen & Steers proprietary analysis, Survey of Professional Forecasters, University of Michigan Survey of Consumers.
Returns represent annualized average, categorized according to whether U.S. gross domestic product and the U.S. Consumer Price Index were above or below their prior-year estimates, based on the Philadelphia Federal Reserve Survey of Professional Forecasters 4-quarter-ahead real GDP forecast and the University of Michigan Survey of 1-Year Ahead Inflation Expectations, respectively.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. Global Stocks represented by MSCI World Index. U.S. Bonds represented by ICE BofA U.S. Treasury 7-10 Year Bond Index. Real Assets Blend represented by a blend comprised of 27.5% Real Estate, 27.5% Commodities, 15% Natural Resource Equities, 15% Infrastructure, 10% Short Duration Fixed Income, and 5% Gold. Real Estate represented by FTSE Nareit Equity REITs Index through February 2005; FTSE EPRA/Nareit Developed Index thereafter. Commodities represented by S&P GSCI Index through July 1998; Bloomberg Commodity Index thereafter. Natural Resource Equities represented by 50/50 Blend of Datastream World Oil & Gas and Datastream World Basic Materials through May 2008; S&P Global Natural Resources Index thereafter. Infrastructure represented by 50/30/20 blend of Datastream World Gas, Water & Multi-Utilities, Datastream World Pipelines and Datastream World Railroads through July 2008; Dow Jones Brookfield Global Infrastructure Index thereafter. Short Duration Fixed Income represented by ICE BofA 1-3 Year US Corporate Index. Gold represented by the gold spot price in U.S. dollars per Troy ounce.

Finally, as a result of investors heavily discounting inflation risks, real asset valuations appear attractively valued relative to stocks and remain near the bottom of their long-term performance cycle versus the market.

The blue line in Exhibit 8 chronicles the relative growth of $1 invested in a diversified real assets blend as compared to global equities. When the line is rising, real assets are outperforming; when it’s falling, stocks are outperforming; and when it’s trending sideways, returns of both are in line. Over the long-term, the trendline is relatively flat, indicating similar returns.

Ratio of real assets blend vs global equities(a) (May 1991 – June 2023)

At June 30, 2023. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream and Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any market forecast set forth in this presentation will be realized.
(a) Global Stocks represented by MSCI World Index. Real Assets Blend represented by a blend comprised of 27.5% Real Estate, 27.5% Commodities, 15% Natural Resource Equities, 15% Infrastructure, 10% Short Duration Fixed Income, and 5% Gold. Real Estate represented by FTSE Nareit Equity REITs Index through February 2005; FTSE EPRA/Nareit Developed Index thereafter. Commodities represented by S&P GSCI Index through July 1998; Bloomberg Commodity Index thereafter. Natural Resource Equities represented by 50/50 Blend of Datastream World Oil & Gas and Datastream World Basic Materials through May 2008; S&P Global Natural Resources Index thereafter. Infrastructure represented by 50/30/20 blend of Datastream World Gas, Water & Multi-Utilities, Datastream World Pipelines and Datastream World Railroads through July 2008; Dow Jones Brookfield Global Infrastructure Index thereafter. Short Duration Fixed Income represented by ICE BofA 1-3 Year US Corporate Index. Gold represented by the gold spot price in U.S. dollars per Troy ounce.

However, relative performance has often shown large dispersion, indicative of long-lived diversification benefits. On the far right of the graph, we can see that following the “Great Disinflation” decade following the GFC, real assets reached a relative performance low the like of which we’ve seen only twice before, during the Dotcom bubble that collapsed in 2000 and on the eve of the 1970s “Great Inflation.” Time will tell where we go from here, but prudent investors should certainly take into consideration the obstacles we may encounter on the road ahead.