Sticky Inflation Risk: Rethinking What “Defensive” Means in 2026

Asian institutional investors are facing a familiar challenge in a less familiar regime: U.S. inflation may remain elevated and more volatile even as global growth stays resilient. In that environment, the biggest risk is not just higher headline CPI (Consumer Price Index) - it’s the knock-on effects of shifting policy paths across regions, higher-for-longer global yields, and changing correlations between equities and duration that can weaken traditional diversification.

Why Inflation May Stay Sticky

Over the past several quarters, real GDP growth across major global economies has generally rebounded, and market concerns over an imminent recession have eased noticeably. However, even as macroeconomic data continues to improve, inflationary pressures have not receded as quickly as expected. Some sources of inflation are increasingly structural in nature, such as supply-chain reconfiguration, tariff-driven cost increases, and more accommodative fiscal policies, keeping inflation persistently elevated. From an asset allocation perspective, sustained inflation not only affects valuation frameworks but also reshapes the risk–return dynamics across asset classes, prompting capital to rotate accordingly.

In the United States, the “One Big Beautiful Bill Act” (OBBBA), expected to take effect in the first half of 2026, will provide additional economic momentum through incentives for corporate capital expenditure and tax rebates for households. While supportive of growth, the policy also raises the risk of more persistent inflation. In Europe, despite inflation readings recently coming in stronger than expected, the European Central Bank may still deliver one final rate cut in the first quarter of 2026. Thereafter, fiscally driven demand is likely to push inflation higher again, further constraining the scope for monetary easing. These inflation dynamics underscore the need for portfolios to strike a careful balance between offensive growth exposure and defensive resilience.

Structural Drivers of Elevated Inflation

Although global trade tensions have eased materially, tariff measures remain in place and continue to exert upward pressure on corporate costs, limiting the pace of inflation normalization. Importantly, only part of the tariff impact has thus far been reflected in consumer prices, with residual effects likely to emerge over time. Meanwhile, corporates have increasingly adapted to a new supply-chain paradigm, with regionalization and “de-China-ization” strategies expected to continue reshaping cost structures over the coming years. AI-related capital expenditure provides additional support to the U.S. economy, contributing to more persistent growth and inflation relative to other regions and resulting in greater policy divergence.

Implications for Duration, Equities, and Diversification

For Asia-based institutional investors, inflation risk is often transmitted through global markets. If inflation remains persistent in the U.S. and other major regions, long-dated yields can face upside pressure. That matters for institutions that hold meaningful global duration, because higher yields can be a headwind for long-duration bond prices precisely when diversification is expected to work. 

The same inflation dynamic that can lift long-end yields can also put pressure on equity valuations. US equity valuations, measured by price-to-earnings multiples, are more than two standard deviations above their 20-year average, even as corporate earnings remain robust. Risk appetite remains constructive, with recent market pullbacks followed by swift recoveries, indicating continued investor willingness to deploy capital in a “buy the dip” investment approach. Nevertheless, elevated valuations, a more hawkish Federal Reserve tone, and rising inflation risks underscore the need for portfolios to retain upside participation while improving resilience to downside shocks that can accompany inflation surprises.

To diversify away from duration and equity risk, larger allocations higher yielding credits, real assets equities, and diversified currency exposures have a place in the portfolio.  Within currency exposures, countries and regions with higher carry and moderating inflation relative to the US have a place in the portfolio.  While it depends on the specific asset, these generally have been less correlated to duration and equity risk during periods of stubborn inflation.

 In summary, inflation is likely to remain sticky in the near term. That said, certain assets could benefit from such an environment. Investors should continue to reassess existing portfolios with care, adopting a flexible approach that balances offensive growth and defensive resilience. By remaining disciplined about diversification and positioning across market cycles, investors can enhance resilience and remain well positioned to capture opportunities in this new inflationary regime.