The longstanding 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 rethink 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 assess the possible effects on both “risky” assets (usually stocks) and “safe” assets (such as U.S. Treasury bonds). United). Traditional investment advice is to allocate funds according to the 60/40 rule: 60% of the portfolio should be in higher-yielding, but more volatile stocks and 40% should be in lower-yielding, lower-volatility bonds. The reasoning is that stock and bond prices are generally negatively correlated (when one goes up, the other goes down), 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 yields will follow a reverse pattern. Likewise, 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 returns turn negative, because rising yields, led by higher inflation expectations, will drive down their market price. Consider 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 have risen with the overall return on long-term bonds reaching -5% in 2021.
In the last three decades, bonds have offered an overall negative annual return only a handful of times. The drop in inflation rates from double-digit levels to very low single-digit levels produced a prolonged bull market in bonds; yields fell and bond returns were highly positive as their price rose. The last 30 years, therefore, have contrasted sharply with the stagflationary years of the 1970s, when bond yields soared along with higher inflation, leading to huge market losses for bonds.
But inflation is also bad for stocks, because 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 stocks and bonds, as it did in the 1970s. In 1982, the S&P 500 price-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-lauded growth and technology stocks are immune to a rise in long-term interest rates, because these are “long-lived” assets whose dividends are farther in the future, making them more sensitive to downturns. a higher discount factor (yields on long-term bonds). In September 2021, when 10-year Treasury yields rose just 22 basis points, stocks fell 5-7% (with the tech-heavy Nasdaq falling more than the S&P 500). ).
This pattern has extended into 2022. A modest 30 basis point increase in bond yields has triggered a correction (when total market capitalization falls by at least 10%) on the Nasdaq and a near correction on the S&P. 500. If inflation remained well above the US Federal Reserve’s 2% target rate – even if it falls modestly from today’s highs – long-term bond yields would rise much higher, and stock prices could end up in bearish territory (a drop of 20% or more).
More specifically, if inflation remains higher than it has been in recent decades (the “Great Moderation”), a 60/40 portfolio would 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 for protecting the fixed income component of a 60/40 portfolio. The first is to invest in inflation-indexed bonds or short-term government bonds whose yields appreciate 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 kinds of political and geopolitical risks that may 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-dated bonds, gold and real estate will change over time and in complex ways depending on macro, policy and market conditions. True, some analysts argue that oil and energy -along with other commodities- can 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, this much is clear: sovereign wealth funds, pension funds, trusts, foundations, family businesses, and individuals who follow the 60/40 rule should Start thinking about diversifying your holdings to protect yourself from rising inflation.
The author
Professor Emeritus at New York University Stern School of Business, he is Chief Economist at Atlas Capital Team, a fintech and asset management firm that specializes in hedging against inflation and other exceptional event risks.
