Inflationary Tailwinds and Policy Divergence: A Strategic Case for Equities and Inflation-Linked Bonds

The global economic landscape in 2025 is marked by a rare confluence of forces: falling unemployment, lagging tariff pass-through effects, and anticipated central bank rate cuts. These dynamics are creating a fertile ground for risk assets, particularly equities and inflation-linked bonds, as investors navigate a world of divergent monetary policies and asymmetric inflationary pressures.

Falling Unemployment and the "Missing" Inflation

The U.S. unemployment rate has averaged 4.2% in Q2 2025, hovering near the Congressional Budget Office's estimate of the non-cyclical rate. Despite this historically tight labor market, inflation has remained stubbornly below expectations. The 12-month headline CPI stands at 2.4%, with core inflation at 2.7%, far from the 4%+ levels seen during the post-pandemic surge. This "missing inflation" is a puzzle for economists but a boon for investors.

The key lies in the lagged effects of tariffs and structural shifts in the labor market. While the U.S. Trump administration's tariffs have raised input costs for businesses, companies have absorbed these shocks through inventory stockpiling, supplier renegotiations, and margin compression. The result? A delayed but inevitable pass-through to consumer prices. By 2026, the Federal Reserve's own staff projects a 1.8% increase in the average effective tariff rate, translating to a $2,400 per household income loss and a broad-based inflationary uptick.

Meanwhile, the labor market's resilience—driven by robust prime-age participation (83.5%) and a 1.05 job openings-to-unemployment ratio—has kept wage growth moderate. Real wages have even risen due to disinflation in food and energy, fueling consumer spending without triggering a wage-price spiral. This creates a window for equities, particularly in sectors like industrials and materials, which benefit from inflationary tailwinds and infrastructure spending.

Monetary Policy Divergence: A Tailwind for Risk Assets

Central banks are diverging in their responses to this environment. The Federal Reserve, while cautious, has signaled two 25-basis-point rate cuts by year-end 2025, with the federal funds rate expected to fall to 4.0% by late 2026. The ECB has already cut rates by 50 bps in 2025, with the deposit rate at 2.15%, while the BoE remains data-dependent, holding the Bank Rate at 4.25% despite UK inflation at 3.4%. China's PBOC, meanwhile, has slashed rates by 10 bps in Q2 and signaled further easing to counter deflationary pressures.

This divergence is critical for investors. The Fed's rate cuts, combined with the ECB's and BoE's more aggressive easing, are creating a "yield chase" in global bond markets. Inflation-linked bonds, particularly U.S. Treasury Inflation-Protected Securities (TIPS), are gaining traction as a hedge against the eventual inflationary surge from tariffs and labor market tightness. The 10-year TIPS breakeven inflation rate has risen to 2.8%, reflecting market expectations of a 2.5% peak in 2026.

Why Equities and Inflation-Linked Bonds Now?

The current setup is uniquely favorable for two asset classes:
1. Equities: Sectors with pricing power (e.g., industrials, energy, and consumer discretionary) are well-positioned to absorb input cost increases and pass them to consumers. The S&P 500's energy sector has already outperformed, with E&P stocks rising 12% year-to-date. Additionally, rate cuts will reduce borrowing costs for corporations, boosting earnings and valuations.
2. Inflation-Linked Bonds: As the lag in tariff pass-through resolves, TIPS and other inflation-linked bonds will offer a dual benefit: capital preservation and a hedge against rising prices. The 10-year TIPS yield is currently at 1.2%, but with inflation expectations rising, these instruments could outperform nominal bonds by a significant margin.

Risks and the Path Forward

While the case for risk assets is compelling, investors must remain vigilant. The lag in tariff pass-through is not infinite; by mid-2026, the full impact of higher input costs could push inflation above 3%, forcing the Fed to delay rate cuts. Additionally, global trade tensions and geopolitical risks could disrupt supply chains and inflation trajectories.

However, the current environment—marked by low unemployment, moderate wage growth, and a Fed poised to cut rates—offers a rare opportunity to position for both inflationary and deflationary scenarios. A diversified portfolio with a tilt toward equities and inflation-linked bonds can capitalize on the asymmetry: equities benefit from growth and rate cuts, while TIPS protect against inflationary surprises.

Conclusion

The interplay of falling unemployment, lagging tariff effects, and divergent monetary policies is creating a unique inflection point for investors. By prioritizing equities with pricing power and inflation-linked bonds, portfolios can harness the tailwinds of a transitioning economy while mitigating downside risks. As the Fed and global central banks navigate this complex landscape, the time to act is now—before the next wave of inflationary pressures emerges.