# Can someone explain the bond vs equity relationship during inflation?



## bigmoneytalks (Oct 3, 2014)

Hi guys
I keep getting contradictory information on the relationship between equity and bonds during inflation. To start , equity and bonds have an inverse relationship that is my understanding but from what I read, it says that it's good to stay invested in equities when inflation rises. This doesn't make sense to me. If inflation rises so do bond/interest rates/ yields (to slow down inflation) and so if yields go up, wouldn't investors move their money away from equities to get a more guarantee return? Yield that is. Thinking this would very attractive to those who are in retirement

Can someone explain this to me? I'm sure I'm missing something


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## Eder (Feb 16, 2011)

Equities have shown to be pretty solid during all inflation scenarios.









*Monthly US Equity Returns by Inflation Regime, 1947 to 2021*


Not sure about bonds...could make out like a bandit as a bond investor buying long term bonds yielding over 10 % but most likely by then you'd all be already broke.


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## Ukrainiandude (Aug 25, 2020)

Eder said:


> Equities have shown to be pretty solid during all inflation scenarios.
> 
> View attachment 22220
> 
> ...


Returns before or after the inflation?


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## ian (Jun 18, 2016)

Let's say the acceptable interest rates are 3 percent. You buy a $1000. 3 percent bond.

IF interest rates jump to 5 percent would you be willing to buy a new 3 percent bond. Probably not. BUT...you would be willing to buy a 3 percent bond IF the purchase price was less than the $1000. face value of the bond in order to 'make up' for the lower interest rate. Say $900 or so...it would depend on how many years are left until the bond matures.

Opposite if interest rates fall to 1 percent. All of a sudden your 3 percent bond is very attractive. It will command a higher price than the face value...


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## Eder (Feb 16, 2011)

Ukrainiandude said:


> Returns before or after the inflation?


Before inflation


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## Ukrainiandude (Aug 25, 2020)

Eder said:


> Before inflation


So inflation at %10 , equities giving you negative 9% return. Even regular HISA will give you better returns.


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## GreatLaker (Mar 23, 2014)

I don't think it is really such a simple relationship. Stocks tend to do well during times of low or slightly increasing inflation. Consumers start to expect a bit of inflation so businesses can raise prices greater than cost increases, increasing their profit. But if inflation gets too high, bond issuers must raise the interest rate on new issues to give investors an adequate real return, otherwise they hold cash. With higher rates on new issues, prices for existing bonds will fall, so holders of those bonds get hurt. If they sell them the get low prices, and if they hold to maturity they lose out to inflation. Then when interest rates rise, the equity premium starts to drop, so investors start selling off stocks because they expect a higher risk adjusted return on bonds. 

That is what happened in the stagflationary mid-1970s. Inflation increased significantly for a number of reasons including costs of the Vietnam war, the oil crisis and gold prices increasing. Bonds plunged because interest rates were so high. Stocks plummeted because fixed income rates went up so much. It resulted in a bear market that lasted until the early 1980s. It was so bad that Business Week published a cover story "The Death of Equities".

This blog is a good discussion of inflation (which often affects investment returns):
Rational Reminder Episode 150: The Ultimate Inflation Hedge
Their basic conclusions are that real return bonds are a good long-term inflation hedge if your timeline aligns with the term of the bond, but not a short-term hedge since they tend to be long dated and volatile. Short-term debt and nominal bonds are good inflation protection because their rates go up if inflation increases. Regarding gold they said "gold might be an effective inflation hedge if the investment horizon is measured in centuries". And their main conclusion: "So, building a diversified portfolio, as usual, is probably a good thing, and I think that's probably the....best way to deal with expected and unexpected inflation".


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## james4beach (Nov 15, 2012)

bigmoneytalks said:


> I keep getting contradictory information on the relationship between equity and bonds during inflation. To start , equity and bonds have an inverse relationship that is my understanding
> . . .
> Can someone explain this to me? I'm sure I'm missing something


I agree with @GreatLaker that this is not a straightforward relationship. Equity and bonds don't really have an inverse relationship. There can be periods where they move together, so I think it's incorrect to think about them as inverse (it's not a guarantee).

Equities tend to be pretty solid investments during inflation, so in a moderate inflation environment, it's fine to hold equities. However as explained in the post above, high interest rates (due to runaway inflation) can also destroy equities. Stocks did terribly in the 1970s. Everyone hated stocks by the time the 1980s arrived.

Again, there are no guarantees. One really should hold a *diversified portfolio of stocks + bonds*. That's really the only way to tackle this problem. And remember, we might not get inflation going forward. We might actually get deflation. Nobody knows! Economists are absolutely useless at forecasting inflation.

Certain kinds of bonds are quite good during times of inflation. Historically speaking, short term bonds and t-bills (or savings accounts) have done a good job keeping up with inflation. GICs are another way to do this. Since they are effectively like short-term bonds, GICs are a fine strategy during inflation.

For a retiree, a portfolio such as 50% global equities and 50% bonds/GICs with a leaning towards short-term bonds, would probably be a pretty good, inflation-resistant portfolio. e.g.

50% XAW (or add some Canada in there)
25% GICs or XSB <-- short term fixed income
25% XBB <-- longer term fixed income


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## bigmoneytalks (Oct 3, 2014)

Thanks all. I know that nobody knows what the future holds but this got me thinking about my my portfolio...I'm 80 percent equities at 20 percent bonds (50/50 long term and short term)... considering diversifying and adding more bond exposure to protect from situations like the 70s...maybe adding preferred stocks? They go up when interest rates go up, right?


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## Eder (Feb 16, 2011)

Ukrainiandude said:


> So inflation at %10 , equities giving you negative 9% return. Even regular HISA will give you better returns.


That's monthly return...multiply by 12 to get annual return. So if inflation hit 10% historically you could expect a real return of about 4%/year.


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## kcowan (Jul 1, 2010)

You also have to consider the yield you are losing while you hold those bonds for insurance. That is why the operative range of 40/60 to 60/40 is considered the best over 30 years.


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## agent99 (Sep 11, 2013)

Another consideration, is that all equities will not react the same. Utility stocks that distribute a steady dividend may react differently to inflation and higher interest rates, than a growth stock might.


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## sags (May 15, 2010)

ian said:


> Let's say the acceptable interest rates are 3 percent. You buy a $1000. 3 percent bond.
> 
> IF interest rates jump to 5 percent would you be willing to buy a new 3 percent bond. Probably not. BUT...you would be willing to buy a 3 percent bond IF the purchase price was less than the $1000. face value of the bond in order to 'make up' for the lower interest rate. Say $900 or so...it would depend on how many years are left until the bond matures.
> 
> Opposite if interest rates fall to 1 percent. All of a sudden your 3 percent bond is very attractive. It will command a higher price than the face value...


Thanks for that clear understandable explanation of the basic premise.


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## Covariance (Oct 20, 2020)

bigmoneytalks said:


> Hi guys
> I keep getting contradictory information on the relationship between equity and bonds during inflation. To start , equity and bonds have an inverse relationship that is my understanding but from what I read, it says that it's good to stay invested in equities when inflation rises. This doesn't make sense to me. If inflation rises so do bond/interest rates/ yields (to slow down inflation) and so if yields go up, wouldn't investors move their money away from equities to get a more guarantee return? Yield that is. Thinking this would very attractive to those who are in retirement
> 
> Can someone explain this to me? I'm sure I'm missing something


Shortish answer - Essentially (most) bonds have a fixed income stream, Whereas some business can increase prices they charge in response to changing costs. So if prices rapidly increase (inflation) the value of the bond‘s fixed income stream purchasing power is eroded. Whereas the company that can increase prices and pass along input cost increases will see its equity value increase or at least stay the same in current dollars.


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## TomB16 (Jun 8, 2014)

agent99 said:


> Another consideration, is that all equities will not react the same. Utility stocks that distribute a steady dividend may react differently to inflation and higher interest rates, than a growth stock might.


Good point.

When I started investing, in the early 80s, Market gamblers moved money between equities and bonds based on macro factors. Bonds would explode when the market would panic. That was before the ETF fad.

Some people continue to present this as how the market works but it hasn't been like this for two decades.

When the market dips, my REITs and utilities typically go up. Lately, they have been soaring, perhaps in anticipation. Of a market correction.

Also, everyone except me seems to think a Bond ETF is equivalent to owning bonds. It isn't.

So, it does appear that some money still moves into bonds during a pull back but money also moves into REITs, utilities, and R-E during a stock pull back.

For my part, under current conditions, I'm happy having several years of living reserve sitting in cash.


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## doctrine (Sep 30, 2011)

Equities do very well during high inflation. Because ultimately they are businesses and can raise prices over time and maintain margins if the product and/or services they provide are important enough. And they are the ones innovating to lower costs and those that do will be rewarded.


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