Navigating Stagflation Fears: Why Diversification Through Alternatives Will Help.

As the conflict in the oil-producing Middle East persists, investors are understandably worried about its economic impact. Just as we were relieved that the excessive inflation from the Ukraine conflict seemed under control, the US Federal Reserve hit the brakes on rate cuts. Their concern? Rising oil prices could reignite inflationary pressure.

This comes at a time when the global economy is already slowing significantly. The IMF is projecting advanced economy growth to be lower in 2025 than the already modest 2024 levels.

For investors, few periods are as perilous as when high inflation converges with rising unemployment and a weak economy—a scenario commonly known as stagflation. The most striking historical parallel is the 1970s, a decade also triggered by a sharp increase in oil prices. The dismal asset returns of that era are now weighing heavily on investors, given the striking similarities to the situation we face in mid-2025.

The 1970s Playbook: What Performed, What Didn't

As the DB graph illustrates, traditional assets like bonds and equities barely kept pace with inflation in the 1970s. The true outperformers were commodities, including precious metals. This historical performance is already prompting a widespread re-evaluation of the conventional 60:40 stock:bond asset allocation. If the 1970s experience repeats, it would deal another significant blow to this long-held strategy.

Crucially, two investment strategies widely available today were largely absent in the 1970s: Alternative Assets and Private Credit. Both possess characteristics that could deliver superior returns to traditional assets should stagflation re-emerge.

Defensive Bond Strategies

Many investors saw values in their fixed interest portfolio retreat in 2022 when the Central Banks of the world embarked on rate hike cycles. What was considered a defensive asset in fact had significant price variation even though the hold to maturity return was unchanged. This rethink of what defensive really means is important because, as already noted, bonds tend to do poorly during periods of stagflation.

The assets with the strongest defence against permanent valuation change are those with contracted cash flows, offering predictable returns and capital values at maturity. Bonds with fixed rate returns will almost always return to face capital value but take some time to do so.

Inflation-linked bonds with short maturities can be effective against short-term inflation spikes, they can also underperform like regular fixed-rate bonds if interest rates continue to rise or if inflation expectations prove too high. Lower than expected actual inflation occurred as recently as 2023 as the "Buy 5 Year Inflation linked Bond v 5 Year Nominal Bond" chart illustrates. In this chart the white line is the price of the 2025 CPI linked bond over time and the orange line is the 2025 nominal bond. Investors often found themselves needing to time the market to preserve capital gains, a notoriously difficult skill.

Buy 5 Year Inflation linked Bond v 5 Year Nominal Bond

Source: Bloomberg

Alternative Assets: Beyond the Traditional Toolkit

Alternative Assets broadly encompass investment types that gained prominence in the 21st century. While once exclusive, hedge funds introduced the concept of "absolute return", prioritising positive returns over simply beating a benchmark. This allows managers to take long or short positions in any financial asset, not just relative to an index, but in an absolute sense.

In today's alternative space, there are widespread tools to augment market index exposure. As Travis Miller, a founder of iPartners, notes in his book ‘Grow Your Wealth Faster With Alternative Assets’, "...fewer investors means less capital available for these investment opportunities. Less supply of capital (from investors) + more demand (from capital raisers/users) = greater returns (but for the same or less risk)." The most effective alternative products aim to participate in market upside while minimising capital losses. Simply owning shares and buying insurance often proves more costly as it's a crowded strategy.

Other under utilised alternative assets include insurance strategies, where investors can gain exposure to very remote risks of loss while still earning attractive returns. Reinsurers have profited from these strategies for over 150 years, yet only recently have they become accessible to sub-institutional investors. Natural disasters, for example, are weakly correlated with equity or bond markets, offering a distinct source of diversification and resilience against valuation volatility. There are myriad alternative assets that can diversify risk and build resilience to stagflationary environments.

Private Credit: Contracted Cash Flows in an Unpredictable World

Fixed-rate bond returns are generally certain for the investment's life but can introduce significant portfolio volatility due to valuation changes that incorporate market price fluctuations. During inflationary periods, fixed returns don't adjust as rates rise, leading to relative underperformance, as shown in the first chart.

Banks have profited from private debt for over 500 years; it's the bedrock of their operations. The emergence of Private Credit in Australia as an accessible asset class for individual investors provides a new way to capture superior risk-adjusted returns. With typically shorter fixed-rate periods or floating-rate returns, private credit offers a strong alternative to the volatility and potential underperformance of both bonds and equities. Investors can aim for above-inflation returns, with returns potentially bolstered if inflation is coupled with higher base interest rates. Much shorter maturities than traditional bonds also allow for pricing realignment to current economic conditions.

For instance, over the past five years, the iPartners Credit Investment Fund has demonstrated very stable returns compared to the fixed-rate bond market.

Private Credit versus Bond returns

Source: iPartners / Bloomberg

Considering the current economic climate and the lessons from history, how are you currently evaluating your portfolio's resilience against potential stagflation?