Bonds-equities dilemma for investors

When faced with rising inflation, conventional wisdom has it, investors move out of fixed-rate bonds and into inflation-linked or interest rate-linked bonds and equities. As global inflation rises, ­however, investors’ behaviour may prove different.

Inflation damages fixed-rate bonds because it undermines the buying power of a fixed-interest payment – if an investor collects 2% interest a year on a £1,000 sum, or £20, £20 buys less and less as inflation rises.

In the short term, the problem worsens when interest rates rise to make borrowing less attractive, slowing the flow of money and cooling inflation. The fixed rate on a bond faces fiercer competition from a higher interest rate.

In the medium term, however, rate hikes can provide relief. If they succeed in lowering inflation, the bond market becomes more attractive.

In Britain, for instance, inflation has been running well above the Bank of England’s target, at more than 3%. But the Bank shows no sign of raising rates to cool inflation, pointing to slack in the economy and upcoming cuts in public spending.

For bonds, none of this is particularly attractive. Brit­ain has a short-term inflation problem but is doing nothing concrete to curb it other than hinting that a weak economy will do the job for it.

In an economic recovery, it would be logical at this stage to move into stocks. Companies can raise their prices in response to inflation, supporting their earnings and cash flow. They can also increase dividends in line with inflation and buy back shares to support their stock price. But this is no normal recovery. The weak economy may hit stocks as well. The public spending cuts are known and priced in to an extent. But contagion from international woes could yet prove tremendous. (article continues below)

Kevin McConnell, the manager of Bloxham’s Midas Global Absolute Return fund, says managers are over­estimating the benefits of developed world stocks that have substantial overseas earnings.

The FTSE 100, for instance, derives more than 60% of its earnings from overseas, according to figures from Artemis and BlackRock. But as McCon­nell says, the savage deleveraging in Europe could have a severe impact on companies’ earnings overseas.

Peripheral eurozone countries with large deficits such as Portugal and Spain are in a race to persuade markets to buy their new debt, at a time when investors are fleeing the eurozone. Greece is already receiving International Monetary Fund and European Union (EU) money, and Ireland has confirmed it will accept some form of aid. Bailing out the periphery is also draining resources in the core countries, several of which are contributing money to bail-outs.

Christophe Akel, a bond manager at GLG Partners, has warned that France could face a downgrade, as it has yet to agree a package to reduce its deficits.

If France were downgraded, the EU would have to restructure its bail-out facility, which depends on support from AAA-rated issuers.

Nor do the problems stop with the eurozone. Other than at the federal level, the public sector in America has slashed spending because of the crisis in the non-federal government debt markets. A wave of foreclosures has hit homeowners.

Now the mid-term elections have ended, Americans are questioning the extent to which the Federal Reserve can continue using quantitative easing to prop up federal debt markets. Significant buyers of federal debt, particularly in the emerging world, have objected to the policy, saying it devalues the dollar and stokes inflation.

A deficit reduction commission, set up by President Barack Obama, is looking at ways to cut public spending, which would hit American earnings.

Emerging markets, although they have more reserves to re-engineer their economies, cannot escape the trend entirely. According to a report on China by the World Bank, domestic demand and investment in the country are deteriorating, but exports have picked up.

China’s main export buyers are Europe and America. Many of the raw materials for its factories come from commodity-driven emerging markets, whose economies could suffer.

If authorities fail to contain problems in the eurozone, the global contagion scenario would hit equities and bonds. Companies that are earning less would face lower share prices and a weakened capacity to repay their debts.

The only positive for fixed income is that spending cuts are disinflationary. For equities, disinflation would be a blow.