In the last two years, investors have had to deal with sluggish global growth, above-target inflation, a trade war as President Trump imposed wide-ranging tariffs on the world and yet another change of UK prime minister. And yet the US stock market has soared to new highs, with the UK and global markets marching upwards in tandem.
Remember though, past performance is not a guide to future returns.
The pre-COVID pattern
After the inflation shocks of the 1970s, the four decades between 1980 and 2020 were characterised by a downward trend in inflation. This allowed global central banks to cut interest rates.
This provided a positive backdrop for bond investors. Stocks gained too as earnings trended higher.
The gains didn’t happen at the same time: when stocks went up, bonds usually went down – and vice versa. But sometimes bad news for earnings could be good news for stocks too.
When the economy slowed and analysts cut their expectations for earnings, they also cut their expectations for interest rates. Lower rates translate into higher valuations, providing some support for stock prices even as earnings came under pressure.
Of course, this was not the whole story. These four decades also included the 1997 Asian financial crisis, the bursting of the dotcom bubble in 2000, and the global financial crisis of 2007-09. But, over the full 40 years, investors made strong gains in both stocks and bonds.
Then came TINA
The COVID-19 crisis led to supply disruptions and worries about recession. A sharp rise in government spending followed. So too did inflation. Indeed, US inflation rose above the Federal Reserve’s 2% target in March 2021 and has not dropped back below that for 62 straight months since.
Sticky inflation and rising government debt has been bad news for bond investors. Stocks were hit too as inflation soared. The relationship between stocks and bonds changed and now they often rise and fall together.
Yet stocks not only recovered, but they also powered on to new highs.
Rising earnings is the most obvious explanation. But the other factor is that investors came to believe that There Is No Alternative – or TINA. With government debt forecast to rise for the foreseeable future, it’s harder to make a case for bonds.
Risk free?
If TINA is one explanation for what’s happened, it’s not a strategy we recommend – except for investors with the highest tolerance for risk and the longest timeframe.
Stock investors should expect a higher return in recognition of the higher risk they face. Stocks typically suffer when recessions hit, pushing down earnings. Valuations typically fall when inflation rises above target levels. And they might fall in any case given their elevated levels, particularly in the US technology sector.
There are certain assets and strategies that can offer some protection against inflation – gold, value stocks and real assets such as real estate. But we find that none of these are guaranteed to succeed when most needed.
For most investors, we suggest the best protection against inflation is a combination of stock investments and a sufficiently long investment horizon – typically 5 years or more – long enough to see through the initial negative impact of rising prices.
Investing can help your money grow, but the value of investments can rise and fall, so you could get back less than you put in.
Stocks are not a hedge against inflation. Instead, they offer above inflation expected returns for long term investors. But bonds still have a role to play. They provide a secure income, and government bonds can protect investors when a recession hits.
This article is for information only and not personal financial advice. If you’re not sure what’s right for you, a financial adviser can help.