It’s a long time since markets last had to deal with a double whammy of rising inflation and rising interest rates. With inflationary concerns bubbling up aggressively, exacerbated by the war in Ukraine, it’s a quandary for both policymakers and investors alike.

On the one hand, there are worries that higher inflation could erode the diversification benefits of bonds. On the other, there are nagging concerns that it could lead to too big a rise in borrowing costs and, as a result, choke off economic growth, which would be bad for shares.

However, it’s worth remembering that inflation, which can erode the value of your cash savings over time, is a key reason why investors invest in the first place – so that they can potentially earn returns in excess of inflation over time. Holding cash is not without risk. What you can now buy with £100 hidden under the mattress would only get you about £60-worth of goods in 10 years’ time if annual inflation over that period ran at 5%¹.  

The value of your investments can down as well as up. Even so, shares, have a strong and lengthy track record as an effective hedge against inflation, as the tables below illustrate.

Shares as an inflation hedge

Nominal

* Greatest annual loss is represented by the lowest 5th percentile of annual returns.
Notes: Returns are in GBP. Nominal value is the return before adjustment for inflation; real value includes the effect of inflation.

Real (inflation-adjusted)

Past performance is not a reliable indicator of future results.
Source: Vanguard, using Dimson-Marsh-Staunton returns data from Morningstar, Inc.

The returns data shown applies to shares in general terms, which is another reason to stay diversified across sectors and regions. We’ve seen so far in 2022 just how being diversified can help, with the poor performance of so-called ‘growth’ stocks – the stalwarts of many portfolios in recent years – being offset by the better performance of other sectors. And given the tightrope central banks have to walk on as they strive to quell inflation without triggering a recession, there’s no knowing how stock market sentiment could change in the months ahead.

The performance of bond markets, in turn, will also be swayed by the success or otherwise of policymakers in their pursuit of this delicate balance.

Inverse but harmonious relationship

Shares are an investment portfolio’s growth engine; they historically deliver better returns than bonds most of the time. But they sometimes fall more sharply too. Bonds, in contrast, are a portfolio’s shock absorbers because they rise or fall less sharply when shares falter.

It doesn’t always work that way. Sometimes the relationship breaks down when bonds and shares move in the same direction. You may have noticed, for example, that global stock and bond markets were both weak in the first few months of 2022.

That isn’t a rare event. In fact, when our economists looked at the two decades up to the global pandemic selloff of March 2020, they observed that bonds and shares moved in tandem about 29% of the time.

But they are still historically transient events because over the longer term the diversification benefits of bonds still stand, our research shows². The longer a downturn, the stronger the relationship tends to be.

We recognise that high inflation is one of the primary factors that can disrupt the largely inverse relationship between bonds and shares. But it’s premature to think what we’re seeing now is different, because high inflation would need to be sustained for several years to have a longer lasting and more damaging effect.

Other recent research³ by Vanguard in the US, concluded that ‘core’ US inflation (which excludes volatile energy and food prices) would need to average 3.5% over a 10-year period to fundamentally remove the diversification benefits of bonds in a portfolio. To put this perspective, core US inflation would need to average 5.7% in each of the next five years, when in fact we expect it to end 2022 at 4.9% and to fall to 3.3% by end-2023.

We think there’s a similar pattern evolving in the UK, with inflation likely to peak later this year before descending to more manageable levels.

Poor alternatives

And even if inflation proves more stubborn than we are forecasting, there are other reasons not to stray too far from shares and bonds. This is because the investment alternatives are underwhelming.

Our research found that gold and commodities offered a better inflation hedge than shares over a one-year period – but only if you had the stomach for living through far greater price swings and potential losses⁴. What’s more, over five, 10 and 20 years it was shares – not gold or commodities, more broadly – that provided the best chance of achieving a positive real return at a lower level of risk⁵.

Still, it’s no reason to deviate from the Vanguard investment philosophy, which is that a balanced and diversified low-cost portfolio of shares and bonds and disciplined approach can best help you reach your goals.

 

¹ Vanguard calculations.

² Renzi-Ricci. G and Lucas Baynes, "Hedging equity downside risk with bonds in the low-yield environment", Vanguard Research, January 2021.2

³ Wu, Boyu (Daniel), Ph.D., Beatrice Yeo, CFA, Kevin J. DiCiurcio, CFA, and Qian Wang, Ph.D., “The stock-bond correlation: increasing amid inflation, but not a regime change”. Vanguard Research, September 2021.

⁴ Source: Vanguard calculations, based on data from Bloomberg and the OECD. Notes: Analysis of the short-term beta to UK inflation and volatility of different sub-asset classes. Volatility is calculated as the standard deviation of rolling one-year annualised returns, at monthly frequency. Inflation beta is defined as how much an asset's return increases when inflation goes up by 1 percentage point. The sample period is 31 January 1972 to 31 October 2021.

⁵ Source: Vanguard calculations, based on data from Bloomberg and the OECD. Notes: Analysis of the proportion of real five-, 10- and 20-year returns that have been above 0% for global equities, UK equities, gold and commodities. The sample period for the monthly data is 31 January 1975 to 31 October 2021. Volatility is calculated over monthly returns of the entire sample period. Indices used: global equities = MSCI World Net Total Return Index; UK equities = MSCI UK Net Total Return Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.