As European inflation hits levels not seen since the 1980s, investors are asking if it’s too late to hedge. Consumer prices in the Euro Area continue to climb, rising 8.1% from a year-ago in May, posing fierce challenges for policy makers trying to contain it without throwing the economy into recession.

European Inflation Dynamics

The dynamics of higher inflation are mostly global in nature. Russia's invasion of Ukraine has upset global supply chains that are still recovering from the COVID pandemic, and cut the supply of many vital commodities, driving prices sharply higher. These pressures – particularly acute in Europe -- are broadening out across countries and products. Production of steel, fertilizer, and paper has shrunk. China’s zero-COVID policy lockdowns are compounding the supply shortages in areas such as the auto sector, which has slowed production, with more delays expected.

Near term uncertainty is very high, but in our base case view, we expect inflation in Europe to peak this year – later than in U.S. – as supply chains recover and monetary and financial conditions tighten.

Still, we believe it will be a slow and sticky process, and remain elevated well into 2023, before gradually moving back toward the ECB’s target -- and the upside risks to our outlook are significant.

Near-term inflation risks appear skewed to the upside

The current environment is uncertain and the range of outcomes for European inflation remains wide. We think the balance of risk is skewed to the upside:

• Dependence on Russia: The EU’s heavy dependence on Russia for gas and vital agricultural commodities suggests inflation may be more intractable there until it pivots to other sources.
• Inflation-growth spiral: The longer realized inflation remains high, the greater the risk that behaviors change, leading workers to demand higher wages and consumers to pull forward purchasing.
• Growth versus inflation trade off: Europe faces a difficult balancing act. Amid weak economic growth, policy makers are boxed in with little room to maneuver relative to their U.S. counterparts, and may need to tolerate higher inflation if the alternative is a policy-induced recession.
• Fiscal policy: Europe’s move to diversify away from Russian energy imports and to increase defense spending point toward higher government spending over the coming years.

Investment implications

Is it too late to hedge inflation risks? We don’t think so. In our view, inflation hedges remain cheap relative to history and are not appropriately reflecting the upside risks to the inflation outlook, meaning that inflation hedges in Europe may still be attractively priced.

To illustrate this, we look at the 5y5y forward breakeven rate. This rate shows the 5-year expected rate of inflation 5 years from today, giving us a full 10-year period for expectations without the near term noise in the standard 10-year breakeven rate. European 5yr5yr inflation swaps indicate that investors expect a rate of 2.2% medium term, only slightly above the ECB’s medium-term target of 2.0%. Market-based inflation expectations in Europe remain below the post GFC peak reached in 2012 and broadly in line with the ECB target.

Market prices for inflation hedge cheap relative to actual consumer inflation

We believe real and inflation–linked assets can provide investors with a powerful hedge against further upside shocks and improve portfolio level diversification and return potential. Even as the pandemic and war related price pressures dissipate, we think it is unlikely that we return to the pre-pandemic paradigm of low but stable growth and inflation. Rather, we believe over the next five years the global economy will likely experience more volatile, and divergent inflation paths. Against this backdrop, investors should consider the full range of potential outcomes and position portfolios to be robust across a range of macroeconomic environments.

Read more insights on our inflation views.

Lorenzo Pagani is a portfolio manager focused on European government bonds. Peder Beck-Friis is a portfolio manager focused on global macroeconomic trends. Both are contributors to the PIMCO blog.