Stockwatch: bonds, equities or cash – my investing tactics

Reflecting on events of the past few weeks, analyst Edmond Jackson studies the different asset classes and reveals his approach to investing in a financially unstable environment.

It is not just central banks in a dilemma this week – if not months ahead – as to inflation and interest rates. 

They are between a rock and a hard place: high inflation persists, reinforced now by wage rises; yet raising interest rates on the back of several major banks collapsing risks more fear, hence financial instability. 

Investors are equally challenged: to discern a safe haven that retains flexibility – beyond cash rotting away in low-interest (if any at all) deposit accounts. 

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Traditionally, equity portfolios have been balanced with government bonds given their performances have tended to correlate inversely. 

But last year, and as inflation rose, so did expectations for equity yields - especially those minuscule and long-dated, like on technology and growth stocks. This is why the US Nasdaq index fell around 30% versus the S&P 500 down 15%.  

Is it safe to step into government bonds? 

Long-term US treasury bonds – traditionally a safe haven in international finance – were no recourse, falling around 20% only with the yield rising from 1% to 3.5%. Consensus is for inflation to fall, but if it sticks, say, at 6%, then theoretically at least, treasury yields need to be nearer 8%, implying another 50% capital downside. 

What about index-linked UK gilts for inflation protection? Even a diversified portfolio - as represented for example by the iShares £ Index-Lnkd Gilts ETF GBP Dist (LSE:INXG) - has been hit by higher inflation/interest rates.  

Past performance is not a guide to future performance.

From early 2007 to end-2021, this exchange-traded fund (ETF) tripled under very low inflation and interest rates; but with such conditions increasingly seen as abnormal, its price had halved by last October’s UK mini-budget and at just over £14 its price remains around 40% down from its peak. 

But what’s the point buying with fresh money if you broadly agree with the Office for Budget Responsibility, that inflation will fall below 3% by end-2022? You might consider a fund such as Vanguard UK Long Duration Gilt Index Fund £ Acc, which aims to track the performance of the 15+ years UK government bond index. 

I’ll wait for equity bargains given persistent inflation

Ultimately, I cannot trust claims by some economists and authorities that inflation will be sorted by year-end. 

It took Paul Volcker as chair of the US Federal Reserve six years before inflation reached 2% after it peaked near 15% in March 1980. The Federal Funds rate (at which the Fed lends to banks) rose from an 11% average in 1979 to a 20% high in June 1981. 

Yes, the talk now is for jitters in the banking community, effectively to pile on monetary tightening – such that central banks need not raise rates further. So, it’s “buy the drop” in equities, yet again. 

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But doing this conveys stagflation risk if banks focus on shoring up their balance sheets rather than lending money. Meanwhile, a tight labour market everywhere means wage awards are likely to peg inflation in at least mid-single-digits. Even if a recession ensues, I suspect on the other side we will have to come to terms with at least 4% inflation. Central bankers talking of 2% inflation targets shows worryingly how detached from reality they remain, and after famously telling us it was “transitory”. 

In the UK, pressure on consumers mounts: telecoms bills are about to hike by inflation plus 3% and the energy price cap will be removed after June. Stable petrol prices seem the only respite. 

What might be realistic alternatives for investment capital? 

The medium to long-term goal is surely to hold quality equities to protect against inflation and achieve hopefully capital growth and income. 

But along the way, and if recession is becoming more likely, then apart from special situations, you might prefer to wait before committing (further) capital to equities. 

Some advisers suggest parking capital in short-dated government bonds – possibly due to an inverted yield curve, where short-dated yields are typically greater than long-dated – although I have reservations. 

Say a greater financial panic evolves and triggers a circa 20% drop in stock markets. You need ability to average in after a big drop. Instinct to do so might be muted if involving a two-stage decision: selling bonds to buy equities, with associated commissions.  

You could end up no better off than if keeping cash on deposit, even at very modest interest, if your prime long-term objective is equities. 

Possibly money market funds could help, but my sense is that these were far better alternatives in the early 1990s recession when they paid a decent return - even offering prompt liquidity. 

Might gold regain favour if only on a speculative basis? 

If you think it could take at least a year or more before financial woes work through, and stock markets genuinely start pricing for recovery, then gold-related assets will appeal. 

Despite my being a cynic on gold – that its price is essentially speculative, any boom containing seeds of a bust – I would say investors are only now waking up to how bad long-term government bonds have recently proven as a “safe haven”.  

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My hunch is that gold-related assets will rise – also other precious metals – in the medium term, partly because the choice of liquid “safe havens” is so few and debatable.  

A perennial dilemma is whether to buy physical gold or mining equities – hence embracing stock market risk – or an ETF. 

Unwinding excess could take longer than equity bulls hope 

Equity prices are firming and early reports express hope that things will have settled down by the weekend – after the Silicon Valley Bank (NASDAQ:SIVB) and Credit Suisse (SIX:CSGN) debacles. 

Yet they are merely symptoms of excess liquidity and ultra-low interest rates during the QE years. Partly why SVB failed is that so much money has been created - there are now an estimated $1 trillion deposits over the US insured threshold. Once such capital turns fearful, no wonder there’s a “bank run”. 

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A parallel exists with last October’s UK pension crisis, when funds needed £65 billion of support from the Bank of England after becoming over-exposed to falling long-dated government bond prices. Yet their capital allocation had been a rational response to BoE officials insisting inflation was “transient” after excess QE.  

All eyes are on central bank actions currently 

For what the BoE governor’s track record is worth, he has recently guided investors “not to assume UK interest rates will rise further, as the UK’s inflation dynamics do not necessarily match those of the US and EU”. 

In the US, economists are divided as to whether the Federal Reserve should raise its interest rate this week by even a compromised 0.25% (or 25 basis points, in the jargon).  

Some say it is crazy to raise rates, as the US economy will tip into a recession given a credit crunch is effectively under way. Monetary policy has swung too tightly from excessively loose. 

Others believe that a 6% Federal Funds rate is required versus 4.8% currently, otherwise even higher rates will be required to contain inflation. 

Attempting to reconcile such views just leads to “stagflation". 

Supposedly, the US stock market bottoms 70% of the way into a recession, or 70% of the way through a Fed monetary-easing cycle. 

It could therefore be premature to assert “buy the drop” generally until inflation eases without a recession manifesting. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.