Inflation, a challenge for bonds and shares

It’s rare for bond and share markets to weaken at the same time as they recently did. It usually requires something astonishing, like the fright stemming from the global outbreak of COVID in March 2020 that simultaneously downed defensive as well as growth assets.

The phenomenon of shares and bonds moving in step may become more frequent if high inflation persists.

In environments where economic growth is the main driver of markets, shares and bonds, in combination, provide diversification.  

When economic growth is strong, shares do well but bonds weaken on expectations of higher interest rates, and the opposite occurs during weak growth periods.

But when inflation is the driving force, the typical bonds-shares relationship weakens, and bonds are far less able to provide diversification against equities. In other words, sustained inflation makes it tough going for bonds as well as shares.

The harm done to bonds and shares by high inflation is more than theoretical speculation. What happened during the terrible inflation of the 1970s is a reference point.

Traditional bonds struggled against the inflationary assault of that era. As for shares – companies did deliver earnings growth, but high inflation suppressed rewards to shareholders.

High inflation discounts the future value of cash flows measured in present terms, and so high inflation is bad for equity valuations.  

We need to bear this in mind as we unpack modern financial markets. While there has been earnings growth across major share markets over the past decade, valuations have generally expanded by more than profits. This has been especially true for big name technology companies who have seen their price-earnings ratios swell thanks to previously low inflation.

However, what low inflation giveth, high inflation can taketh away. The challenge ahead for investment professionals like us is to develop solutions to steer portfolios through this.

Traditional fixed income assets like government bonds are vulnerable to capital losses while high inflation persists, and central banks embark on a cycle of raising interest rates. However, this doesn’t mean portfolio compositions should walk away from all forms of fixed income.

True diversification requires fixed income in the mix, albeit by looking in different places.  Together with our investment consultant, we will be considering where opportunities might exist, and areas where risk can be minimised.  Whilst we cannot guarantee investment returns, we can guarantee you will have a team of professionals considering your best interests when managing your investments.

There are no shortcuts, no magic formulas to delivering strong long-term returns. What matters is diversification, constantly reviewed investment programs, discipline, and having the courage of your convictions to stick by your investment philosophy and process regardless of the fashions or fears of the day.

Please call the office if you would benefit from speaking to an Adviser about your investments at (03) 5224 2700.

The article contains adapted content published by MLC Asset Management, 10 May 2022.