Market Watch: Inflation Will Hurt Both Stocks and Bonds, So You Need to Rethink How You'll Hedge Risks

Article by Nouriel Roubini (Professor at New York University) in Market Watch

Rising inflation in the United States and around the world is forcing investors to assess the likely effects on both “risky” assets (generally stocks) and “safe” assets (such as U.S. Treasury bonds).

During a “risk-on period,” when investors are optimistic, stock prices and bond yields will rise and bond prices will fall, resulting in a market loss for bonds; and during a risk-off period, when investors are pessimistic, prices and yields will follow an inverse pattern. Similarly, when the economy is booming, stock prices and bond yields tend to rise while bond prices fall, whereas in a recession, the reverse is true.

Negative returns on bonds

But the negative correlation between stock and bond prices presupposes low inflation. When inflation rises, returns on bonds become negative, because rising yields, led by higher inflation expectations, will reduce their market price. Consider that any 100-basis-point increase in long-term bond yields leads to a 10% fall in the market price—a sharp loss! Owing to higher inflation and inflation expectations, bond yields have risen and the overall return on long bonds reached -5% in 2021.

Over the past three decades, bonds have offered a negative overall yearly return only a few times. The decline of inflation rates from double-digit levels to very low single digits produced a long bull market in bonds; yields fell and returns on bonds were highly positive as their price rose. The past 30 years thus have contrasted sharply with the stagflationary 1970s, when bond yields skyrocketed alongside higher inflation, leading to massive market losses for bonds.

But inflation is also bad for stocks, because it triggers higher interest rates—both in nominal and real terms. Thus, as inflation rises, the correlation between stock and bond prices turns from negative to positive. Higher inflation leads to losses on both stocks and bonds, as happened in the 1970s. By 1982, the S&P 500 price-to-earnings ratio was 8, whereas today it is above 30.

Inflation hurts equities too

More recent examples also show that equities are hurt when bond yields rise in response to higher inflation or the expectation that higher inflation will lead to monetary-policy tightening. Even most of the much-touted tech and growth stocks aren’t immune to an increase in long-term interest rates, because these are “long-duration” assets whose dividends lie further in the future, making them more sensitive to a higher discount factor (long-term bond yields).

In September 2021, when 10-year Treasury yields rose a mere 22 basis points, stocks fell by 5% to 7% (and the fall was greater in the tech-heavy Nasdaq).

This pattern has extended into 2022. A modest 30-basis-point increase in bond yields has triggered a correction in the Nasdaq and a near-correction in the S&P 500. If inflation were to remain well above the Federal Reserve’s target rate of 2%—even if it falls modestly from its current high levels—long-term bond yields would go much higher, and equity prices could end up in bear country (a fall of 20% or more).

More to the point, if inflation continues to be higher than it was over the past few decades, a 60/40 portfolio would induce massive losses. The task for investors, then, is to figure out another way to hedge the 40% of their portfolio that is in bonds.

Three options for hedging

There are at least three options for hedging the fixed-income component of a 60/40 portfolio.

The first is to invest in inflation-indexed bonds or in short-term government bonds whose yields reprice 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 hit the world in the next few years).

Lastly, one can invest in .......

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