This article first appeared in The Financial Times.

We have not had to worry about inflation for 15 years, and in its absence, complacency has set in. Investors in the U.S. are pricing in an average of 1.75 per cent inflation over the next 10 years, based on implied rates in the Treasury Inflation-Protected Securities market. That is frighteningly low. Investors should not underestimate the possibility of the improbable.

It would take only a subtle shift in the breeze for inflation to shift course in 2020. And having remained weak for so long, the final re-emergence of inflation will have an outsized effect on investors’ appetite for risk. Even a small surprise outside the current range would present a major challenge for the markets. We saw that play out towards the end of 2018 when the U.S. Federal Reserve’s preferred measure, the core personal consumption expenditure index, briefly rose to 2.04 per cent. The S&P 500 dropped 14 per cent over the fourth quarter.

In the U.S., inflation conversations often revolve around how much the average American is earning. In the latest non-farm payroll report, wage growth fell below 3 per cent for the first time since July 2018, despite record unemployment. That flies in the face of what every economics textbook says should be happening. The absence of growth in wages, during a period of sustained economic recovery, has led investors to believe that inflation will not materialize any time soon.

But that overlooks two factors that contribute to the core PCE and core consumer price inflation calculations.

The first is medical care costs, which represent 20 per cent of the core PCE index, and just under 10 per cent of core CPI. Medical bills have been increasing at an annual rate of about 5 per cent, a trend that will continue as the population continues to age. Additionally, the healthcare insurance component of CPI is increasing at a dramatic pace, most recently hitting 20 per cent, a multi-decade high.

Second, housing costs have an outsized influence over the inflation rate, representing some 40 per cent of core CPI and about 20 per cent of Core PCE.

Weakness in America’s residential housing market has bottomed out, and U.S. house prices are now poised for further price appreciation. Housing starts and sales of existing homes have both showed signs of strength, while sentiment among home builders is at its best level for more than 20 years.

We have the Fed to thank for that reversal in fortunes, and its three interest rate cuts in quick succession last year. For the first time in nearly 50 years, 30-year fixed mortgage rates dipped below the rate of wage inflation (for production and nonsupervisory employees) in late 2019.

After years of modest price rises, investors have become immune to inflation risk and are increasingly unwilling to pay the insurance premium to protect their portfolios. Retail investors have rotated away from the traditional inflation-hedging products — Tips, commodities and real-estate investment trusts — in favour of sectors with juicier yields. Institutional investors seem to have headed in the same direction.

The eventual return of inflation will be read by investors as a harbinger for the end of the excessively easy monetary conditions that have propelled the current economic expansion. And when it hits, there will be a rush towards Tips and real assets. This could quickly jam up liquidity in these small markets. Sleepy investors who have failed to protect their portfolios against inflation will be caught flat-footed.

Investment-grade bond yields would be likely to rise, particularly for longer maturities. The yield on the Bloomberg Barclays Aggregate Index ended last year at just 2.3 per cent, with a duration of 5.9 years. Compare that to 2007, when the yield was 4.4 per cent and duration was 4.4 years. Today’s bond market offers just over half of the yield, while requiring investors to accept 1.5 years of additional duration risk to achieve that yield.

Meanwhile, collateralized loan obligations — specialist vehicles that took a battering in 2019 — might see their floating rates become attractive again, if the Fed sought to curtail inflation with rate rises.

However, for that to happen, the Fed would have to change course. And that seems unlikely. The central bank is due to conclude its review early this year on whether it has the right tools at its disposal to support the health of the U.S. economy. It has already indicated that it is open to tolerating inflation running above target.

A return of above-target inflation could cause a sudden spur of volatility, from which there will be winners and losers. Investors should stay on their toes in the meantime. Generally, the biggest threats are the ones that consensus tells us will not happen. A portfolio hedged against inflation risks is one that is better prepared.

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.