Ignoring Inflation Warnings Will Melt US Stocks for a Decade

In the early stages of inflation, investing in bonds is not advisable because interest rates continue to rise. Rising interest rates lead to falling bond prices, so bond or deposit investments should be avoided during this period. However, when inflation is expected to peak, long-term bond investments should be considered. When interest rates reach their highest point, long-term bonds, such as 30-year bonds, become more attractive as they can lock in high interest rates for an extended period.

When inflation declines and a recession occurs, bond prices tend to rise, offering investment returns. This is due to the tendency for bonds to react before stocks in a traditional business cycle. Therefore, investors should flexibly adjust their bond investment timing according to changes in the inflation phase.

In a traditional business cycle, bond prices rise significantly during a recession, allowing investors to realize profits by selling bonds. This is due to increased demand for bonds driven by expectations of falling inflation and interest rate cuts.

Subsequently, as expectations of falling inflation and interest rate cuts materialize, prices of risk assets such as stocks begin to rise. It was a common investment strategy for investors to move funds from bond sales to risk assets like stocks, increasing their allocation. However, recently, there have been indications that this traditional cycle is not mechanically operating, suggesting a need for flexible responses.

Since 2022, the market has anticipated a recession, but instead, inflation has repeatedly risen without a recession occurring. This is considered an abnormal trend, diverging from traditional business cycles. Unlike in the past, massive liquidity provision by governments and active policy intervention are delaying the entry into deflation.

This situation can be interpreted as a breakdown of the typical business cycle. The analysis suggests that excessive money printing has prevented a transition to deflation and maintained inflationary pressure. If a recession does not materialize, a long-term bond investment strategy based on the premise of a recession is likely to fail.

The current inflation cycle is at a stage where interest rates are highly likely to rise further. It is important to view the market with a medium-to-long-term perspective of 6 months to 1 year ahead, rather than focusing on short-term consumer price index (CPI) data.

In particular, establishing an investment strategy that considers economic changes up to 2027-2028 is recommended. This means preparing for inflation and interest rate changes from a long-term perspective rather than reacting to short-term market volatility.

According to economist Irving Fisher's concept of 'money illusion,' people tend to confuse nominal and real values. The current tax structure taxes only nominal interest rates, so in a high-inflation environment, after subtracting the inflation rate from the real interest rate and paying taxes, an investor's real purchasing power declines even further.

For example, even if the same real interest rate of 2% is guaranteed, the after-tax real return will be lower in countries with higher nominal interest rates. This suggests that it is difficult to determine if an investment is attractive simply because its nominal interest rate is high during inflation. Investors must carefully consider real returns and after-tax real returns, not just nominal returns.

According to Bridgewater's analysis, the inflation trajectory in the 1973 oil shock era is very similar to the current one. The first oil shock and the second energy crisis due to the Iranian Revolution overlap with current geopolitical risks such as the Russia-Ukraine war. In the past, a Keynesian interpretation viewing these as external shocks was dominant, but from a monetarist perspective, the fundamental cause of 1970s inflation is analyzed to be the monetary expansion that occurred before the oil shock.

In particular, it is argued that the massive money supply increase by President Lyndon Johnson to fund the Vietnam War and build the 'Great Society' in the 1960s triggered inflation. This can be interpreted similarly to the current situation where governments worldwide have supplied massive liquidity and expanded fiscal spending after the COVID-19 pandemic. Thus, the perspective is presented that fundamental monetary policy changes, rather than simple external shocks, may be the core cause of current inflation.

After the COVID-19 pandemic, the scale of government fiscal deficits in various countries has grown incomparably larger than in the 1970s. Regardless of who is in power, governments are prepared to inject massive funds, which is why bond interest rates, such as the US 30-year Treasury yield, are not easily falling, even after temporary dips.

With such massive fiscal deficits, a decline in interest rates is difficult to expect. Furthermore, the analysis suggests that current geopolitical risks are acting as a trigger for price increases, similar to the 1970s oil shock.

While the current economy may be relatively favorable for large corporations like Samsung or Hynix, small and medium-sized enterprises and self-employed individuals are facing severe difficulties. This economic downturn can lead to overall social instability, manifesting as social side effects such as random crimes.

If such social instability becomes extreme, governments may face a situation where they have to inject money again to stimulate the economy. Similar to the severe social chaos and breakdown of public order in New York in the 1970s, a recurrence of a similar situation cannot be ruled out. This demonstrates the limits of monetary policy and suggests a scenario where government fiscal injection becomes inevitable.

The 1970s was a period of severe inflation, during which both bonds and stocks recorded negative real returns. This is an important historical example demonstrating that the general formula of continuously rising stock prices can be broken. At that time, the best investment assets were real assets such as gold, oil, and commodities.

In particular, after the Nixon Shock, as the link between gold and the dollar was severed, gold emerged as an alternative in the era of fiat money, showing a massive surge. The analysis suggests that real assets effectively served as a store of value in an inflationary environment. Therefore, it is necessary to pay attention to real assets even in the current inflation phase.

From around next year, a significant portion of the funds that have been concentrated in the stock and real estate project financing (PF) markets over the past decade are expected to shift to the bond market. This is because changes in asset allocation are inevitable as the rising interest rate trend continues.

As interest rates rise, the attractiveness of bonds is relatively increasing. Therefore, investors need to adjust their portfolios by expanding their bond investment proportion, according to the analysis.

The current inflation level is expected to stabilize at an average of 2.5% to 3% annually. This falls between the high inflation era of the 4% range in the 2000s and the low inflation era of the 1% range in the 2010s.

The entry into this moderate inflation era suggests that extremely low inflation, as seen in the past, is unlikely to return. The current situation, with the US 10-year Treasury yield at 4.75% and the 30-year yield at 5.3%, reflects this stabilization of moderate inflation.

Some experts, including Elon Musk, argue that the AI era will bring deflation through a productivity revolution, but this seems to be a distant future. Instead, the process of building and operating AI systems requires massive resource input, which is likely to intensify inflationary pressures.

Building AI infrastructure, such as data centers, high-performance semiconductors, and securing energy resources, incurs large costs. Therefore, over the next 3-5 years, AI-related investments are expected to act as a factor stimulating inflation. The deflationary effects of productivity gains will appear in the long term.

The strategy of holding and waiting with US 30-year bonds has been analyzed as essentially akin to an investment 'hoping for a crisis, please let it happen.' While bonds can play a defensive role during a recession, their effect is negligible in a stagflationary environment.

Even if deflation occurs, the bond investment strategy should differ depending on whether it leads to a severe economic contraction like a financial crisis or merely a temporary adjustment. The warning is that relying solely on long-term bonds in uncertain situations like the present is risky.

Since the 2008 financial crisis, government-led economic policies have been strengthening globally. This means that regardless of whether it's a left-wing or right-wing government, we have entered an era where immense amounts of money are being spent. The current trend of expanding fiscal deficits has reached a point that is difficult to reverse.

In a situation where government-led economic policies are entrenched, reducing fiscal expenditure is virtually impossible. This situation is analyzed as the fundamental reason why inflation does not easily fall below 2% and the era of moderate inflation persists. The explosive increase in fiscal expenditure after COVID has further exacerbated this phenomenon.

Governments, burdened by massive debt, are likely to opt for a strategy of tolerating inflation to reduce the real value of their debt. Inflation has the effect of reducing the real value of nominal debt.

In such a situation, an investment strategy relying solely on US 30-year bonds may have limitations. It is difficult to expect a simple interest rate decline when the government is intentionally managing inflation.

Many young Wall Street experts in their 30s and 40s built their careers mostly during the neoliberal era of low interest rates and low inflation. They have not fully experienced the current economic situation where high inflation, high interest rates, and complex geopolitical crises are intertwined.

Therefore, there is a risk that they may be stuck in past successful methods, offering investment strategies not suitable for the current era. The need for new investment perspectives and strategies appropriate for the current geopolitical crises and rapidly changing economic situation is pointed out.

The current inflation cycle, in the phase of rising prices, is diagnosed as being akin to the 'top of the 7th inning' in a baseball game. This means that it has reached about the middle of the inflation upswing.

A turning point for inflation is projected for mid-to-late next year, with the possibility of repeated situations where inflation temporarily falls and then rises again.

A diversified strategy combining growth assets and income assets was proposed as a suitable portfolio for the current situation. It is advisable to allocate about 40-50% to growth assets with expectations for AI transformation and growth potential. This reflects expectations for technology sectors that will drive future industrial changes.

A strategy of replacing traditional bonds with high-yielding income assets like US 30-year Treasury bonds is also effective. It was emphasized that it is important to diversify holdings of assets that provide stable income, such as dividend stocks and various types of credit bonds. In particular, the traditional 60/40 portfolio (60% stocks, 40% bonds), which was a successful strategy in the past low-inflation era, is no longer effective in the recent market environment, he warned.

In the current era of moderate inflation, a flexible and diversified portfolio strategy different from the past is needed. Simply focusing on growth stocks or relying on specific bonds is risky; it is crucial to diversify risk and pursue stable returns through various asset classes.

During periods of rising inflation, the cost of raw materials needed to build new homes significantly increases, adding to the burden of new home supply prices. This acts as a factor limiting the decline in prices of existing homes, as higher construction costs for new homes help maintain the relative value of existing properties.

Therefore, real estate can be evaluated as an asset that maintains a moderate value even in crisis situations. The analysis suggests that real estate possesses defensive capabilities as a real asset in an inflationary environment.