Inflation risk, also referred to as purchasing power risk, is the risk that the real value of an investment’s returns will be eroded by a rise in the general price level of goods and services over time. It is a central consideration in long-term capital planning, since even nominally positive investment returns can result in a loss of real purchasing power if the rate of inflation exceeds the nominal rate of return. Inflation risk affects different asset classes and portfolio structures in different ways, and its significance tends to vary depending on the broader macroeconomic environment.
Historical context
For much of the period following the 2008 global financial crisis, inflation was largely absent from mainstream investment conversation in developed economies. Low inflation, low interest rates, and accommodative central bank policy characterised this period, creating conditions in which a wide range of asset classes performed well simultaneously. As a result, many portfolios were constructed around assumptions — about interest rates, asset correlations, and the relative attractiveness of different investment structures — that were specific to that low-inflation environment.
This changed with the sharp rise in consumer prices that began in 2021, driven by a combination of supply chain disruption, energy price shocks, and labour market tightness. Toby Watson, a finance professional whose career included nearly seventeen years at Goldman Sachs across structured finance, principal funding, and global investment roles before he joined Rampart Capital as a partner in 2020, has described this episode as one of the more instructive lessons of recent years, illustrating that portfolios built for one macroeconomic environment may be poorly positioned for another.
Why inflation risk is often underestimated
Inflation risk is frequently misunderstood as a single, uniform threat, when in practice it represents a set of related but distinct challenges affecting different parts of a portfolio in different ways. Most investors understand, at a basic level, that rising prices erode purchasing power and that portfolios need to generate real rather than nominal returns. What is less well appreciated is how profoundly a sustained shift in the inflation environment can disrupt the assumptions underpinning long-term capital planning — assumptions about interest rates, asset class correlations, and the relative attractiveness of different investment structures.
Impact on fixed income
The impact of inflation on fixed income assets is considered among the most direct of any asset class. When inflation rises, central banks typically respond by raising interest rates, which pushes down the prices of existing bonds — particularly those with longer maturities, since long-duration bonds are more sensitive to changes in prevailing interest rates. Toby Watson, whose experience at Goldman Sachs spanned structured finance and global investment roles across multiple market cycles, has framed the lesson not as an argument against holding fixed income in a long-term portfolio, but as a case for managing duration risk carefully when the inflation outlook is uncertain.
Impact on equities
The relationship between inflation and equity performance is more complex than that between inflation and fixed income. Some equity sectors have historically performed reasonably well during inflationary periods, while others tend to struggle. This divergence means that a portfolio’s exposure to inflation risk through its equity holdings cannot be assessed simply by its overall allocation to equities, but requires closer examination of the specific characteristics of the companies held.
Real assets and inflation protection
Real assets — including infrastructure, commodities, and certain categories of real estate — have historically been regarded as offering a degree of protection against inflation, on the basis that their value or income streams are, to varying degrees, linked to price levels. However, the degree of protection varies considerably depending on the specific asset and the nature of the inflationary episode in question. Toby Watson’s work in hard asset lending during his time at Goldman Sachs gave him practical exposure to how tangible assets behave when monetary conditions shift, and this grounding informs a more nuanced view of what inflation protection actually means in portfolio terms — including the distinction between assets with genuine inflation-linking characteristics and those assumed to provide protection based on historical correlations that may not hold in all environments.
Managing inflation risk in long-term portfolios
Long-term capital planning under conditions where inflation is a persistent risk requires a different set of disciplines than planning in a low-inflation environment. The emphasis shifts from capturing returns in a relatively stable environment to preserving real value across a range of possible outcomes. Commonly cited disciplines include:
- Scenario analysis — thinking through how different inflationary outcomes would affect each component of a portfolio, rather than relying on a single baseline forecast.
- Genuine diversification across assets with different inflation sensitivities, as distinct from diversification that appears sound on paper but breaks down when macroeconomic conditions shift.
- Careful management of duration in fixed income allocations, since shorter-duration instruments tend to offer more resilience when inflation and interest rates are rising.
Broader relevance
Toby Watson — whose career at Goldman Sachs and subsequent work at Rampart Capital have given him a wide-angle view of how markets behave across different economic regimes — has framed the broader lesson of the post-2021 inflationary episode as a reminder that long-term capital planning should always be stress-tested against conditions that differ from those currently prevailing. Structural conditions in financial markets can shift in ways that are difficult to anticipate, and portfolios built around a single set of macroeconomic assumptions carry risks that may not be visible until those assumptions are challenged. Resilience across a range of outcomes is generally regarded as a more reliable foundation for preserving capital over time than optimisation for any single expected environment.
