share_bond_crash

Harvey Jones
23.02.22

This is going to hurt – how inflation could destroy both stocks and bonds at the same time
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Opposites attract, they say, and that is certainly true of shares and bonds. The two asset classes work in very different ways, and that's why they work so well together. Or have, up to now.
Shares offer higher long-term returns, with short-term volatility. Bonds give investors safer, steadier, lower returns.
Shares and bonds are called non-correlating assets because when one goes up, the other typically goes down, and vice versa.
When investors are confident they buy shares, when they're nervous they race to bonds as a safe haven.
That's why many investors follow the 60/40 rule, putting 60% of their portfolio in shares, and 40% in bonds.
Theoretically, that should deliver a much smoother overall return. But what happens if stocks and bonds crash at the same time?
Think it won't happen? Noble prize winning economist Nouriel Roubini says it already is. His new paper, Inflation Will Hurt both Stocks and Bonds, argues that rising inflation in the US and beyond could make the 60/40 rule obsolete.
Is he right and how should you respond?

Inflation is negative all round
Mr Roubini says the negative correlation between stock and bond prices presupposes low inflation, but those days are over as US consumer price growth rockets to a 40-year high. Accelerating inflation is bad for stock markets, because it drives up interest rates, raw material costs and wages, which squeezes economic growth.
We are now seeing the impact on the fastest-growing sector of the last decade, US technology stocks.
Higher inflation erodes the value of their future cash flows, while driving up their borrowing costs, making today's dizzying valuations harder to justify.
Resurgent inflation is also bad for bonds because they pay a fixed rate of interest, and this is suddenly worth a lot less in real terms.
At time of writing, 10-year US Treasuries yield just below 2%, while US inflation stands at a thumping 7.5%. This means bond investors are getting a negative yield of -5.5% in real terms.
Bonds face another challenge. While interest rates drive up yields, this forces down bond prices, smashing the value of existing holdings.
The drop is brutal, as Mr Roubini notes. “Any 100-basis-point increase in long-term bond yields leads to a 10% fall in the market price – a sharp loss.”
While bond yields rose in 2021, the overall return on long bonds was negative at -5%, he says.

Stagflation is bad for both asset classes
Ever since policymakers cracked inflation in the early 1980s, investors have enjoyed decades of stock and bond bull markets.
Now we are hurtling back to the stagflationary 1970s, Mr Roubini says, a period “when bond yields skyrocketed alongside higher inflation, leading to massive market losses for bonds”.
The negative correlation between shares and bonds turned positive in the 1970s, as both crashed at the same time. Now it’s happening again.
Bond yields are rising today, and that is hitting stock markets, Mr Roubini says, noting that a modest 30-basis-point increase in bond yields triggered a correction in the US Nasdaq index, defined as a fall of more than 20%.
Mr Roubini's conclusion: “If inflation continues to be higher than it was over the past few decades, a 60/40 portfolio would induce massive losses.”
It seems logical, and others are issuing similar warnings.

Growth stocks are out, value is back in
With the US Federal Reserve set to hike interest rates three to seven times this year, bond market volatility “looks a certainty”, analysts at Barclays Private Bank warn.
Chief market strategist Julian Lafargue says: “If inflation remains elevated for an extended period, there may be few places to hide.” So where should you hide?
Mr Lafargue says commodities and inflation-linked bonds can protect investors from inflationary storms, while others favour value stocks.
Ian Lance, co-lead of fund manager Redwheel’s UK Value and Income team, says tech titans such as Microsoft, Apple, Amazon and Google-owner Alphabet may come unstuck in a high-inflation, high-interest rate world, just like the “Nifty Fifty” stocks during the inflationary 1970s. “Investors may reflect this by reducing their exposure to growth equities, and increasing exposure to value stocks, especially the energy, mining and banking sectors which benefit from rising inflation.”
Value stocks are companies with solid cash flows, regular dividends and reliable earnings, that have fallen out of favour during the recent dash for growth.

There are winners as well as losers
The banking sector may benefit from higher interest rates, because these allow them to widen their net lending margins, the difference between what they charge borrowers and pay savers.
The UK stock market has outsize exposure to financials, and banks such as Barclays, Lloyds and NatWest Group have rocketed more than 60% in the last year.
Higher oil prices have also boosted energy stocks such as BP and Shell, making the FTSE 100 the best performer of 2022.
London’s blue-chip index currently yields 3.18%, more than double the S&P 500’s 1.27%.
Dividends also help your portfolio fight inflation.
Mr Roubini recommends inflation-indexed bonds, as well as short-term government bonds, whose yields reprice rapidly in response to higher inflation.
He also highlights gold. The precious metal tends to rise when inflation is higher, plus it is a good hedge against political and geopolitical risks.
His final tip is to invest in “real assets with a relatively limited supply, such as land, real estate, and infrastructure”.

Exchange traded fund ideas
The easiest way to get exposure to these sectors is through exchange traded funds (ETFs), and there are plenty to choose from.
Investors might consider the Energy Select Sector SPDR Fund or the First Trust Nasdaq Oil & Gas ETF. Or maybe a broader commodity fund, such as the Invesco DB Commodity Index Tracking Fund or iShares S&P GSCI Commodity-Indexed Trust.
For financials, take a look at the Vanguard Financials ETF or Fidelity MSCI Financials ETF.
There are plenty more to choose from.
For inflation-indexed bonds, try ETFs investing in Treasury Inflation-Protected Security (TIPS), such as the iShares TIPS Bond ETF, Schwab US TIPS ETF or Pimco Broad US TIPS ETF.
For property, consider Vanguard Real Estate ETF, iShares US Real Estate ETF or WisdomTree Global ex-US Real Estate ETF.
For gold, consider the Invesco Physical Gold ETC or SPDR Gold Shares.
There are thousands more ETFs out there, just make sure that whatever you buy balances your existing holdings.
Don’t go overboard though, and dump all your bonds.
Central bankers continue to insist that inflation will slow later this year. If they’re right, the 60/40 rule could work again.
In investing, no trend lasts forever.


 

Harvey Jones has been a UK financial journalist for more than 30 years, writing regularly for a host of UK titles including The Times, Sunday Times, The Independent and Financial Times. He is currently the personal finance editor of the Daily Express and Sunday Express, and writes regularly for The Observer and Guardian Unlimited, Motley Fool and Reader’s Digest.

 

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