World markets have, belatedly, started to consider the return of that mythical beast, inflation. Long considered extinct by many, it’s a species whose DNA looks eminently capable of resurrection in the ubiquitous economic laboratory experiments now being undertaken by just about every government and central bank.
Stock markets are directly affected by bond markets because the expected returns of the latter are used as a benchmark to price all other financial assets. Consequently, the recent volatility evident in equity prices can be traced back to the potential effects of inflation undermining real (i.e. after accounting for inflation) bond returns. How much damage might result depends on the magnitude of change in expectations when compared with the initial yield. However, when the yield on 10 year U.S. Treasuries is 1.6% and the yield on their 30 year counterparts amounts to only 2.3%, it is very evident how little wiggle room exists if inflation concerns strengthen even modestly. Should they become more aggressive (3% inflation, anyone?) the bond market will be a bloodbath.
We say this not to cause alarm but simply to illustrate what might happen if inflation overshoots what central bankers and politicians believe possible. Our investment policy remains defensive.
