Inflation and the stock market

A combination of global supply and demand factors has opened the cage to rapid price growth and hence rising inflation. The effects, throughout the world economy, are far-reaching. In the stock market, rising inflation is forcing investors to re-evaluate this variable in their investments, thereby rethinking their strategy.

Conventional wisdom dictates that investment portfolios should be structured with a proportion of high return, high volatility stocks and a proportion of lower return, lower volatility bonds or debt securities. The proportions of one and the other fluctuate between 60/40 or 50/50 and much depends on how investment advisors view the medium term.

The rationale for designing portfolios in this way is that stocks and bonds are usually negatively correlated. That is, when one goes up in price the other goes down. This mix ultimately results in a balanced portfolio with protection from fluctuations and thus stable returns.

In a recent article, the super economist and professor Noriel Roubini, points out that, in periods of low risk perception, investors are optimistic, and stock and bond yields would rise, but this increase in bond yields means a fall in bond prices and a loss in that type of investment. When market sentiment is reversed, yields and prices behave inversely, i.e. stocks fall, but bond prices rise, as their return decreases. Thus expanding markets mean better prices for stocks and better yields for bonds. In a recession, the reverse happens. 

This negative correlation of bonds and stocks presupposes low inflation, says Roubini. And he is right, because when there is inflation, the cost of money rises, and so bond yields rise, but bond prices collapse. And the more inflation, the more money costs and the less bonds are worth.