First, it’s worth recapping our structural observations around inflation. We believe the low inflation, low interest rate, low volatility environment investors have enjoyed in recent decades is giving way to a new, more unstable regime. In short, 2% is now the floor for inflation, rather than the ceiling. And that signals a meaningful change because, for the three decades up to late 2021, we have not had to worry about anything north of 2%.

The previous regime was driven by a series of disinflationary tailwinds. Primarily

• China opening to the world stage and the collapse of the Soviet Union which delivered major positive supply shocks to the global economy by adding cheap labour and resources
• a political backdrop supportive of free trade and globalisation
• technology that allowed businesses to capitalise on global integration
• favourable demographics that ensured a record-high ratio of workers to elderly dependants, flattering welfare state finances

Now, the drivers of this multi-decade period of integration and disinflation are breaking down. Replacing them is a fragmenting world order marked by rolling negative supply shocks. This shift is encouraging greater government intervention, with increased expenditure required for rearmament, ageing populations, the energy transition, crumbling infrastructure, and managing the impact of the technological revolution in AI. At the same time, spending cuts remain politically unpalatable. These dynamics were accelerated by the pandemic and are now increasingly visible in a Trump 2.0 world.

We don’t know where inflation will get to, or exactly where it’s going. But we do know that it tends to come in waves.

The chart below shows the US Consumer Price Index (CPI) over three different periods: the 1940s, the 1970s and the 2020s. The x axis shows a ten year period: the 24 months before the peak in inflation, and the following 96 months.

Why is inflation wavy? Firstly, the conditions that lay the groundwork for inflation don’t fade after just one surge. Inflationary pressures build over time, and the breakdown of the disinflationary tailwinds of the last regime is well underway. Secondly, the policies and the appetite to curb inflation don’t appear after just one episode. Interest rates must usually be hiked – and stay tight – through some economic and market pain. For this to be politically palatable, people must hate the pain of inflation more than they hate the pain of higher interest rates.

So inflation has a tendency for resurgence. And the current US president has made it very clear he would like to see lower interest rates, despite persistent inflationary pressures.

We are not suggesting inflation will reach the levels seen in 2022, nor that we are returning to the 1970s. But we are saying there is an underpriced risk that this is not ‘one and done’.

This age of disruption and changing world order is set against a backdrop of deep and expanding government deficits that show no sign of slowing. Developed economies are running record high peacetime deficits – despite low unemployment. In the US, nearly one fifth of tax revenues are now spent on interest payments alone, exceeding the entire defence budget. But what happens if unemployment rises? Historically, budget deficits have widened by around 4% during downturns.

This creates inherent fragilities. Structural headwinds are making the economy more prone to inflation, just as the scale of government borrowing is making it more sensitive to higher interest rates. The result is a financial system that is less tolerant of both inflation and the policy tools needed to control it.

This matters because inflation alters the relationships between the core building blocks of conventional portfolios. When three year average core inflation exceeds just 2.5%, bonds and equities begin to show a positive correlation. It doesn’t take double-digit inflation to pose a challenge – just a modest overshoot of central bank targets can be enough.

Whilst this shift presents a significant change for most of today’s investors, it is actually a return to the historical norm. The chart below shows the correlation between US stocks and bonds back to 1900. Periods of positive correlation – when both assets move in the same direction – have been more common than not. The real anomaly has been the past few decades, during which bonds (and other duration assets) consistently acted as reliable offsets to equity drawdowns.

The turning point was 2022, when most assets held for diversification proved highly sensitive to rising interest rates – exposing the fragility of portfolios reliant on established assumptions.

To be clear, since 2022, aside from the initial period of disruption, this shift has benefited conventional portfolios, as both major asset classes rose together over 2023 and 2024. The real concern, of course, is if this correlated rise reverses.