Asset correlation and inflation: Is hedging the answer?

In the UK, we’ve had a step up in inflation in recent months and there are arguably several issues that could keep inflation elevated over the longer term, including protectionism or geopolitical issues. As we saw back in 2022, prolonged inflationary pressure can lead to higher correlation between equity and bond market performance, with both underperforming.

Matt Brennan, Head of Asset Allocation, looks at several ways the impact of higher inflation might be hedged in multi-asset portfolios.

Generally speaking, equities and bonds are negatively correlated, which means that when one underperforms, the other tends to outperform. However, when inflation went through the roof in 2022, equities and bonds together experienced a bout of poor performance, as correlation between the two asset classes turned positive. Equities struggled as the higher interest rate outlook – to combat rising prices – signalled a likely economic slowdown. Higher inflation and interest rates also led to weakness in bond markets. This was because fixed bond interest payments and the bond principal lost value in real terms in an environment of rising prices.

In simple terms, inflation-hedging assets are those that are expected to earn returns over and above the rate of inflation.

In recent months, UK inflation has jumped, in part because of the Ofgem energy price cap changes in the spring. For July 2025, inflation reached 3.8%, compared with the Bank of England’s (BoE) 2% medium-term inflation target and the recent low of 1.7% hit in September 2024. The BoE expects this price hump to last for the rest of the year but then predicts inflation should soften thereafter. However, there is potential for prices to run at a higher-than-target level over the longer term. For example, price spikes could be caused by ongoing geopolitical crises, especially if the price of oil and gas gets affected by supply concerns, or trade tariff increases.

In traditional multi-asset portfolios, diversification may mitigate the potential for higher correlation between equities and bonds. Adding assets with the potential to hedge inflation is an option for investors looking to limit the impact of rising prices. In simple terms, inflation-hedging assets are those that are expected to earn returns over and above the rate of inflation. However, these assets do not always deliver what is expected of them, so let’s take a closer look.

Inflation-linked bonds – Some governments issue inflation-linked bonds (ILBs). ILBs have lower correlations with some other bond and equity types, which can make them attractive as part of a diversified portfolio. With ILBs, the principal and/or interest payments increase with inflation (and decrease with deflation). ILBs come with many of the strengths and weaknesses of sovereign debt and have a large and liquid market. However, the range of governments that issue them is limited – the US and UK together making up over half of the market.

The sensitivity of a bond to changes in rates is measured by duration. Duration is expressed in years and is a good measure of interest rate risk. Index-linked bonds tend to have relatively long durations, and to meet market demand to hedge long-term inflation risk, many are issued with long maturity dates. Bonds with higher durations have higher interest rate sensitivity, and vice versa. For example, if interest rates rise, a bond with a duration of ten years would be expected to see its price fall by more than a bond with a duration of five years, and the opposite would be the case as interest rates rise. This rate sensitivity adds to the risks associated with ILBs. Additionally, while ILBs may protect against inflation shocks, they can fail to protect investors if high inflation is coupled with an increase in real yields.

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Private markets – Holding the right type of private assets can diminish inflation exposure. For example, private infrastructure often includes price escalations in contracts for operators of road tolls. Private debt can potentially be a hedge too, as often interest is paid on a floating-rate basis that mirrors the changing interest rate environment. Additionally, private debt is viewed as a less volatile asset as there is has no publicly traded market. Though in difficult environments, such as those of high inflation, default risk could rise. Later this year, Scottish Widows is launching an open-architecture Long-Term Asset Fund that will provide access to a spectrum of private market investments.

Real estate – Propertyassets can also help to hedge against the impact of inflation. As inflation rises, rents can be adjusted upwards depending on the terms of lease agreement terms. However, these will tend to lag inflation if rent reviews are, for example, undertaken annually.

Gold – Periods of high inflation erode the purchasing power of a currency, and gold is used as common substitute for weak currencies in part because of its limited supply and real-world uses. However, the price of gold often doesn’t track inflation, particularly in the short term. It can also be volatile, with its price influenced by an array of factors. For example, when the inflation backdrop is low, gold can see periods of robust valuation increases. Indeed, we have seen gold prices show an inverse correlation to inflation as it has gone from strength to strength since 2023, at a time when inflation globally has been slowing down. This is because gold tends to also do well if there is global geopolitical instability, as investors like to use it as a ‘safe-haven’ asset in difficult times. Additionally, it has also benefitted from purchasing by central banks, including China’s, as they diversify their asset bases.

While we don’t believe there is going to be a return to the inflation extremes of the recent past, we are constantly reviewing asset mixes within our multi-asset funds and analysing economic trends.