Inflation is also bad for the stock market because it causes nominal and real interest rates (the interest rate minus inflation from nominal interest rates). For this reason, when the inflation rate increases, the negative correlation between stocks and bonds changes to a positive (+) correlation. As in the 1970s, deepening inflation causes losses in the stock and bond markets.
In recent cases alone, bond yields rose and bond prices fell on fears that inflation could lead to a tightening of currency At the same time, the stock market was hit. Even recent technology stocks and growth stocks have been shown to be affected by long-term interest rate hikes. These stocks are more sensitive to long-term bonds rates as they have drawn attention for their potential in the distant future. When the 10-year U.S. government bond interest rate rose 22bp in September last year, the U.S. stock market fell 5-7%. In particular, the technology-oriented Nasdaq fell more significantly than the large-cap S&P 500.
This phenomenon continues this year. As bond yields rose 30bp, Nasdaq’s market capitalization evaporated by at least 10%. The S&P 500 was also adjusted. If the inflation rate exceeds the target of 2% of the Fed, the U.S. central bank, long-term government bond yields are expected to rise further, stock prices are expected to fall more than 20%.
Portfolio Hedge Strategy Required
If inflation is formed higher than in the last few decades, the six-to-four portfolio strategy will cause huge losses. If so, the challenge for investors is to find a way to hedge bonds, which account for 40% of their assets.
There are three hedge strategies for the 6-to-4 portfolio. The first option is to invest in inflation-indexed bonds or short-term government bonds that respond quickly to high inflation. The second is to invest in gold or other precious metals, which tend to increase in price when inflation intensifies. Gold shows a rise in prices, especially when various political and geopolitical risks are high. Finally, investing in assets with limited supply such as land, real estate, and infrastructure can be a solution. The optimal combination of the three short-term government bonds, gold, and real estate mentioned above will vary depending on the economic, political, and market conditions.
