The narrative is a straightforward one…
Since the global financial crisis (GFC), central banks around the world have pinned interest rates at – or, in the case of Japan, Europe and Switzerland, below – zero.
They have combined this zero interest rate policy (ZIRP) with unprecedented waves of money printing. This has flooded the global economy with cheap money in an attempt to boost corporate borrowing, increase consumer spending, elevate asset prices – and, ultimately, generate inflation.
Still, year after year, inflation (both general prices and wage inflation) has remained low by historical standards.
However, that could be changing – which means investors could be in for a bumpy few months.
Let me explain…
How low inflation affects bonds and equities
Low inflation is supportive of bond prices because in a low inflation environment, your bond coupon (or yield) is relatively valuable. If a bond pays you 2 percent and inflation is 1 percent, you’re still earning a positive real (i.e., inflation-adjusted) return.
Because inflation has remained stubbornly low for so long, bond yields have stayed low. And low bond yields have also driven cash into the equities markets, where since the GFC, you’ve been able to earn a comfortable dividend yield versus bond yields (see the chart we put together showing the historical S&P 500 dividend yield versus the two-year treasury yield).
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This is because the market knows that the Federal Reserve can’t hike rates aggressively, or even normalise rates, in a low inflation environment. Doing so could simply choke economic growth by increasing borrowing costs.
But inflation might be about to rear its head
The latest year-on-year U.S. average hourly earnings growth rate of 2.9 percent, the highest since 2009, spooked the market. If wages are rising, then it’s likely we’ll see inflation in the broader consumer price index (CPI) measure. And on February 14, we’ll see those numbers released.
The consensus estimate for CPI is approximately 1.9 percent. If we see this level overshot, then we’ll see bonds sell off (i.e., yields increase).
When that happens, higher yields force equity investors to reassess their holdings – a 1.85 percent dividend yield in the S&P 500, for example, might be attractive if 10-year Treasuries yield less than 1.5 percent like they did in mid-2016. But that yield looks a lot less enticing if bonds offer yields of 3 percent or above.
Now, there’s no need to panic by any means. Given the multi-year bull market in equities and multi-decade bull market in bonds, some correction is overdue.
But it’s clear that investors should expect a bumpy few months ahead.
The best way to de-risk your portfolio
First, shorten your bond portfolio duration. We’ve shown you before how much potential hidden interest rate risk you might be exposed to based on a bond’s duration. So focus on bonds with shorter maturities.
Second, trim some of the more interest-rate sensitive stocks in your portfolio. This primarily means higher yielding stocks like real estate investment trusts (REITs), utilities and energy stocks.
And keep an eye out for the Wednesday inflation numbers!