Buy stocks so you can dream, buy bonds so you can sleep—or so the saying goes. A wise investor will aim to maximise their returns relative to risk, defined as volatility in the rate of return, and therefore hold some investments that will do well in good times and some in bad. Stocks surge when the economy soars; bonds climb during a crisis. A mix of the two—often 60% stocks and 40% bonds—should help investors earn a nice return, without too much risk.
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Such a mix has been a sensible strategy for much of the past two decades. Since 2000 the average correlation between American stocks and Treasuries has been staunchly negative, at -0.5. But the recent rout in both stock and bond prices has wrong-footed investors. In the first half of the year the s&p 500 shed 20.6% and an aggregate measure of the price of Treasuries lost 8.6%. Is this an aberration or the new normal?
The answer depends on whether higher inflation is here to stay. When economic growth drives asset prices, stocks and bonds diverge. When inflation drives them, stocks and bonds often move in tandem. On August 10th American inflation data showed prices did not rise in July. Stocks soared—the s&p 500 rose by 2.1%—and short-term Treasury prices climbed, too.
For as long as central bankers kept a lid on inflation, investors were protected. Yet look back before 2000, to a period when inflation was more common, and you see that stocks and bonds frequently moved in the same direction. aqr Capital Management, an investment firm, notes that in the 20th century the correlation between stocks and bonds was more often positive than negative.
Lots of hedge-fund types, pension-fund managers and private-equity barons are therefore worrying about the potential for repeat inflation shocks. Last year the debate in the halls of finance was about whether inflation would be “transitory” or “persistent”; this year it is about whether it is “cyclical” or “structural”.
At the heart of this is not whether central bankers can bring down prices, but whether the underlying inflation dynamic has changed. Those in the “structural” camp argue that the recent period of low inflation was an accident of history—helped by relatively calm energy markets, globalisation and Chinese demographics, which pushed down goods prices by lowering the cost of labour.
These tailwinds have turned. Covid-19 messed up supply chains; war and sabre-rattling are undermining globalisation. Manoj Pradhan, formerly of Morgan Stanley, points out that China’s working-age population has peaked. Jeremy Grantham, a bearish hedge-fund investor, fears that the switch to renewables will be slow and costly, and that lower investment in fossil-fuel production will make it hard for energy firms to ramp up supply, increasing the risk of energy-price spikes. All this, the structuralists argue, means the current inflation shock is likely to be the first of many: central bankers will be playing whack-a-mole for a while yet.
Recurrent inflation would upend 20 years of portfolio-management strategy. If the correlation between stocks and bonds shifts from -0.5 to +0.5 the volatility of a “60/40” portfolio increases by around 20%. In a bid to avoid being wrong-footed once again, investors are updating their plans. As Barry Gill of ubs’s asset-management arm puts it, the task is “to realign your portfolio around this new reality”.
What assets will allow investors to sleep soundly in this new reality? Cryptocurrencies once looked like an interesting hedge, but this year they have fallen and risen in lockstep with stocks. A recent paper by kkr, a private asset-management firm, argues, perhaps unsurprisingly, that illiquid alternatives, like private equity and credit, are a good way to diversify. But that may be an illusion: illiquid assets are rarely marked-to-market, and are exposed to the same underlying economic forces as stocks and bonds.
There are other options. aqr suggests stock-picking strategies where success has little to do with broader economic conditions, such as “long-short” equity investing (going long on one firm and short on another). Meanwhile, commodities are the natural choice for those worried about a disorderly green transition, since a basket of them appears to be uncorrelated with stocks and bonds over long periods. In the search for new ways to minimise risk, investors dreaming of high returns will have to get creative. That, at least, should tire them out by the end of the day.
Read more from Buttonwood, our columnist on financial markets:
Reminiscences of a financial columnist (Jul 28th)
The Fed put morphs into a Fed call (Jul 23rd)
Why markets really are less certain than they used to be (Jul 14th)
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