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Grin And Bear It

Signs point to the start of a bond bear market

Since their peak on 4 August 2020, long duration Treasuries are down 40% in real terms. Similar falls have been seen in other government bond markets around the world. For haven investments, what has happened over the last two years is unprecedented.

"It is structural inflation not cyclical inflation that really matters to investment portfolios"

I do not use that term lightly. Up until last month the largest fall in real bond prices in any 22-month period since 1900 was 34%, experienced in the early 1920s. I have believed for a while that what has happened in recent months was inevitable, based on the observation that inflation and real interest rates got so low that they could only go up – my investment philosophy is that ‘what’ is more important than ‘when’, and that analysis should be kept simple.

My concern however is that while what we have experienced recently is bad, it may well be the start of the bond bear market that I have for several years been advising investors to expect and, more importantly, to prepare for.

It is changing inflation expectations that have the biggest influence on bond prices, nominal or real. However, there are two types of inflation – cyclical and structural – and the key to grasping the import of what we may have to look forward to over the next decade or two is to understand the difference between the two.

An example of cyclical inflation is that associated with the 2008 financial crisis. Inflation accelerated in the 2-3 years leading up to the crisis, driven by the booming housing market in the US, then fell sharply during the particularly nasty recession in 2009. However, with a dose of central bank largesse, we quickly returned to a comfortable regime of gently rising consumer prices. Equities recovered all their losses, and then some. Bond prices continued to rise.

Look at a log-scale chart of the US consumer price index since 1900 and you will hardly notice the cyclical inflation perturbation in 2006/9, nor any of the other economic cycles since the early 80s during which financial markets got their knickers in a twist.

What you will see are the distinct multi-year periods of structural inflation, those when US consumer prices were either gently rising i.e. 1900-1916, 1948-1965, and 1982-2020, falling i.e. 1928-1939, or rising sharply i.e. 1916-1922, 1939-1948, and 1965-1982.

Let me be clear. It is structural inflation not cyclical inflation that really matters to investment portfolios. The last four decades were wonderful ones for investors, as gently and persistently falling inflation lifted both equities and bonds. The period, however, may have made us complacent, oblivious to the possibility, likelihood even, of stubbornly high inflation in the years ahead and the damage it would inflict.

To illustrate, from 1965 to 1981, a US 50/50 balanced fund fell in real terms by a whopping 41%. 1916 to 1922 was similarly dreadful, while 1939 to 1948 saw balanced portfolios in real terms stagnate. By the way, even though they would show a similar pattern, I would much prefer to use UK data, given their greater relevance to readers. Sadly, however, data sources here are not as accessible as they are across the pond. Not even to a What Investment columnist!

As for why structural inflation deviates every few decades from its gently rising norm, there is no one culprit. Unlike economists who go into detail, I like to think of inflation as a measure of the health of a country or region, economically and/or politically. 96.8 degrees is fine. Much higher or lower is not.

The 1916-1922 and 1939-1948 periods of sharply rising inflation were related to the two world wars, with the former getting an additional boost from the so-called Spanish Influenza. As for the high inflation during 1965-1982, although many associate it with the two oil shocks, the actual cause was massive fiscal and monetary policy error in the face of the Vietnam War as well as other problems such as the strains faced by Bretton Woods.

Lately, central banks and governments in many countries appear to have blamed the rapid rise in inflation over the last two years on private sector supply bottle necks caused by Covid-19. In other words, it was temporary.

It may however relate to the massive fiscal and monetary stimulus we have seen in recent years, much of it politically driven, as economic growth first dwindled, then was hit by the pandemic.

Pandemic. Tick. Policy error. Tick. Thank goodness we don’t have war to worry about.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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