Inflation Has Started to Rewrite the Rules of Investment

Nouriel Roubini
By Nouriel Roubini
Rising inflation in the US and around the world is forcing investors to assess the likely effects on both ‘risky’ assets (generally stocks) and ‘safe’ assets (such as US Treasury bonds). The traditional investment advice is to allocate wealth according to the so-called 60/40 rule : that is, 60% of one’s portfolio should be in higher-return but more volatile stocks, and 40% should be in lower-return, lower-volatility bonds. The rationale is that stocks and bond prices are usually negatively correlated (when one goes up, the other goes down), so this mix will balance a portfolio’s risks and returns.

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 (bit.ly/3sZqBAZ); and during a ‘risk-off’ period, when investors are pessimistic, prices and yields will follow an inverse pattern. Similarly, when an economy is booming, stock prices and bond yields tend to rise while bond prices fall, whereas in a recession, the reverse usually holds true. But the negative correlation between stock and bond prices presupposes low inflation. Now, when inflation rises (bit.ly/3LNOHal), returns on bonds become negative, because rising yields, led by higher inflation expectations, tends to 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—which is 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 (on.mktw.net/3H4QO68).

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 prices rose. The past 30 years thus have contrasted sharply with the stagflationary 1970s, when bond yields skyrocketed (bit.ly/3LOcBST) alongside higher inflation, leading to massive market losses for bonds.

Read the full Livemint article.

Nouriel Roubini is a Professor Emeritus of Economics and International Business and the Robert Stansky Research Faculty Fellow.