The prolonged negative correlation between stock and bond prices is an artifact of the low inflation environment of the past 30 years. If inflation and inflation expectations continue to rise, investors will need to reconsider their portfolio strategies to hedge against the risk of massive future losses.
NEW YORK – Rising inflation in the United States and around the world is forcing investors to evaluate the potential impact on both “risky” assets (usually equities) and “safe” assets (such as US Treasury bonds). United). Traditional investment advice is to allocate funds according to the 60/40 rule: 60% of the portfolio should be in higher-yield, but more volatile stocks and 40% should be in lower-yield, lower volatility bonds. The reasoning is that stock and bond prices are generally negatively correlated (when one rises, the other falls), so this combination will balance a portfolio’s risks and returns.
During a “risk-on-period,” when investors are bullish, stock prices and bond yields will rise, while bond prices will fall, resulting in a market loss for bonds; and during a risk-free period, when investors are bearish, prices and returns will follow a reverse pattern. Similarly, when the economy is booming, stock prices and bond yields tend to rise and bond prices fall, while the opposite is true in a recession.
But the negative correlation between stock and bond prices assumes low inflation. When inflation rises, bond yields become negative because rising yields, driven by higher inflation expectations, will drive their market price down. Note that any 100 basis point increase in long-term bond yields leads to a 10% drop in market price – a significant loss. Due to higher inflation and inflation expectations, bond yields increased with the overall return on long-term bonds reaching -5% in 2021.
In the last three decades, bonds have yielded only a handful of times an overall negative annual return. Falling inflation rates from double-digit levels to very low single-digit levels have caused a prolonged bull market in bonds; yields fell and bond yields were highly positive as their price rose. The past 30 years have thus been in stark contrast to the stagflationary years of the 1970s, when bond yields skyrocketed with higher inflation, leading to huge market losses for bonds.
But inflation is also bad for equities, as it drives higher interest rates – both in nominal and real terms. Thus, as inflation rises, the correlation between stock and bond prices changes from negative to positive. Higher inflation leads to losses in both equities and bonds, as in the 1970s. In 1982, the S&P 500 price-to-earnings ratio was eight, while today it is above 30.
More recent examples also show that equities are affected when bond yields rise in response to higher inflation or in the expectation that higher inflation will lead to monetary policy tightening. Not even the much-vaunted growth and technology stocks are immune to a rise in long-term interest rates, as they are “long-lived” assets whose dividends lie further into the future, making them more sensitive to downturns. a higher discount factor (returns on long-term bonds). In September 2021, when 10-year treasury yields rose by just 22 basis points, equities fell 5-7% (with the technology-heavy Nasdaq falling more than the S&P 500).
This pattern extended to 2022. A modest 30 basis point increase in bond yields caused a correction (when total market capitalization fell by at least 10%) on the Nasdaq and an almost correction on the S&P. 500. If inflation stays far above the US Federal Reserve’s target rate of 2% – even if it falls modestly from today’s highs – long-term bond yields will rise much higher, and stock prices could end up in a bearish range (a 20% drop or more).
More specifically, if inflation remains higher than it has been in recent decades (the “Great Moderation”), a 60/40 portfolio will cause massive losses. The task for investors, therefore, is to find another way to protect the 40% of their portfolio that is in bonds.
There are at least three options to protect the fixed income component of a 60/40 portfolio. The first is to invest in inflation-indexed bonds or short-term government bonds whose returns rise rapidly in response to higher inflation. The second option is to invest in gold and other precious metals whose prices tend to rise when inflation is higher (gold is also a good hedge against the kind of political and geopolitical risks that could affect the world in the coming years). Finally, you can invest in real assets with relatively limited supply, such as land, real estate and infrastructure.
The optimal mix of short-term bonds, gold and real estate will change over time and in complex ways, depending on macro, policy and market conditions. Admittedly, some analysts argue that oil and energy – along with other commodities – could also be a good hedge against inflation. But this issue is complex. In the 1970s, it was higher oil prices that caused inflation, not the other way around. And given the current pressure to get out of oil and fossil fuels, demand in those sectors may soon peak.
While the right mix of a portfolio can be debated, it’s clear: sovereign wealth funds, pension funds, trusts, foundations, family businesses and individuals who follow the 60/40 rule must start thinking about diversifying your property to protect yourself from rising inflation.
The author
Emeritus Professor at New York University Stern School of Business, he is chief economist at Atlas Capital Team, a fintech and asset management firm specializing in hedging against inflation and other exceptional event risks.
Reference-www.eleconomista.com.mx