What does inflation and deflation mean for bonds?

By: Frank Knopers

In recent decades, it has been easy for investors to spread their risk. An investment portfolio with 60% in equities and 40% in bonds yielded returns in both good and bad times. Stock prices rose in times of economic prosperity, while bonds performed well in times of crisis. This popular strategy delivered risk-free returns for years, but this year it seems to be delivering the reverse. Risk without return. How can you, as an investor, better protect your assets?

"Past performance is no guarantee for the future." Every investor knows this slogan, but in the world of mutual funds, the combination of stocks and bonds is still the standard. For example, as investors get closer to retirement, they are often advised to hold fewer shares and more bonds. And for the past forty years, this strategy has also worked, because the trend of falling interest rates has structurally supported bond prices. But now that interest rates are rising again and central banks are rapidly raising interest rates, this strategy no longer seems to be working. In combination with the highest inflation in forty years, this requires a different investment strategy.

Stocks and bonds down

Over the past twelve months, an investment portfolio with 60% equities and 40% bonds has yielded negative returns. The US S&P 500 index achieved a return of -11% (including dividend) over this period, while the Barclays U.S. Aggregate Bond Index recorded a similar loss over the same period. Due to rising interest rates, the prices of bonds in this fund fell.

Normally, bond prices are much less volatile than stock prices, but as interest rates get closer to zero, the impact of a small change in interest rates on the value of the bond becomes increasingly significant. A rise in interest rates from 6% to 8%, as happened in 1993, did not have nearly as much effect on the value of bonds as the movement from 1% to 3% that we have seen over the past twelve months.

Bonds offered no protection against falling stock prices this year

Inflation or deflation?

The rise in interest rates over the past twelve months is largely attributable to skyrocketing inflation. Investors demand more interest, because they know that money will have much less purchasing power in a year's time. But in recent weeks, we have also seen deflationary effects on the bond market. For example, the rise in interest rates has recently turned into a decline again, as the market prepares for a recession. If economic conditions deteriorate further, this will be accompanied by a drop in demand, which will reduce inflation and possibly even turn into deflation. That is also the scenario that historian and stock market analyst Eric Mecking will use in the coming years Provides.

What does this mean for bonds in the investment portfolio? Actually, not much good. If inflation remains high, you will still lose a few percent of purchasing power per year even at the current interest rate. If we get a scenario of debt deflation, that is not always favorable for bonds either. In this scenario, the money supply shrinks and consumers keep their hands on the purse strings en masse. In this scenario, bonds become more valuable, but it becomes much more difficult for companies to pay off their debts or roll over. The number of Defaults is likely to increase in this scenario, especially in the more risky bonds and emerging market debt.

It is therefore significant that the Federal Reserve Market Commentary writes that it could take another seven years for the bond market to return to its previous level. In short, there is a good chance that investors will not enjoy their bond portfolio much in the coming years either. Current interest rates are still completely insufficient to compensate for inflation, while price risk is still high with the prospect of more interest rate hikes by central banks.

What can you do as an investor?

You could say that with an investment in high-quality bonds, you will always get your investment back in the end. Those who do not sell their bonds in the meantime have less to worry about a lower market value during the term of the loan. But what is the value of getting back deposits plus a negligibly low interest rate, if inflation is many times higher?

These times therefore call for an investment strategy with more diversification. In addition to stocks and bonds, it may also make sense to add physical gold to the portfolio. Although the precious metal does not generate cash flow, it has historically performed excellently in times of high inflation and in times of economic and geopolitical uncertainty.

Even in a scenario of deflation, gold is of added value in the portfolio. From This research shows that the Gold price in the deflationary period from 1931 to 1934 increased in value against most currencies. Moreover, it appears that periods of deflation rarely last long. Due to the intervention of central banks and governments, deflation eventually turns back into high inflation. For example, the price of gold in the United States rose from $20.67 to $35 per troy ounce in 1933, an increase of almost 70%. The upside potential of gold is therefore many times greater than the downside risk.

Have a look at us YouTube channel

On behalf of Holland Gold, Paul Buitink and Joris Beemsterboer interview various economists and experts in the field of macroeconomics. The aim of the podcast is to provide the viewer with a better picture and guidance in an increasingly rapidly changing macroeconomic and monetary landscape. Click here  to subscribe.  

https://www.quoteinspector.com/images/investing/portfolio-risk/