Rising inflation in the United States and around the world is forcing investors to assess the likely effects on both “risky” assets (generally stocks) and “safe” assets (such as US Treasury bonds).

The traditional investment advice is to allocate wealth according to the 60/40 rule: 60 per cent of one’s portfolio should be in higher-return but more volatile stocks, and 40 per cent should be in lower-return, lower-volatility bonds.

The rationale is that stocks and bond prices are usually negatively correlated (when one goes up, the other goes down), so this mix will balance a portfolio’s risks and returns.

During a “risk-on period’’, when investors are optimistic, stock prices and bond yields will rise and bond prices will fall, resulting in a market loss for bonds; and during a risk-off period, when investors are pessimistic, prices and yields will follow an inverse pattern.

Similarly, when the economy is booming, stock prices and bond yields tend to rise while bond prices fall, whereas in a recession, the reverse is true.

But the negative correlation between stock and bond prices presupposes low inflation. When inflation rises, returns on bonds become negative, because rising yields, led by higher inflation expectations, will reduce their market price.

Consider that any 100-basis-point increase in long-term bond yields leads to a 10 per cent fall in the market price — a sharp loss. Owing to higher inflation and inflation expectations, bond yields have risen and the overall return on long bonds reached -5 per cent in 2021.

Over the past three decades, bonds have offered a negative overall yearly return only a few times.

The decline of inflation rates from double-digit levels to very low single digits produced a long bull market in bonds; yields fell and returns on bonds were highly positive as their price rose.

The past 30 years thus have contrasted sharply with the stagflationary 1970s, when bond yields skyrocketed alongside higher inflation, leading to massive market losses for bonds.

But inflation is also bad for stocks, because it triggers higher interest rates — both in nominal and real terms.

Thus, as inflation rises, the correlation between stock and bond prices turns from negative to positive.

Higher inflation leads to losses on both stocks and bonds, as happened in the 1970s. By 1982, the S&P 500 price-to-earnings ratio was eight, whereas today it is above 30.

More recent examples also show that equities are hurt when bond yields rise in response to higher inflation or the expectation that higher inflation will lead to monetary-policy tightening.

Even most of the much-touted tech and growth stocks aren’t immune to an increase in long-term interest rates, because these are “long-duration” assets whose dividends lie further in the future, making them more sensitive to a higher discount factor (long-term bond yields).

In September 2021, when ten-year Treasury yields rose a mere 22 basis points, stocks fell by 5-7 per cent (and the fall was greater in the tech-heavy Nasdaq than in the S&P 500).

This pattern has extended into 2022. A modest 30-basis-point increase in bond yields has triggered a correction (when total market capitalisation falls by at least 10 per cent) in the Nasdaq and a near-correction in the S&P 500.

If inflation were to remain well above the US Federal Reserve’s target rate of 2 per cent — even if it falls modestly from its current high levels — long-term bond yields would go much higher, and equity prices could end up in bear country (a fall of 20 per cent or more).

More to the point, if inflation continues to be higher than it was over the past few decades (the “Great Moderation”), a 60/40 portfolio would induce massive losses.

The task for investors, then, is to figure out another way to hedge the 40 per cent of their portfolio that is in bonds.

There are at least three options for hedging the fixed-income component of a 60/40 portfolio. The first is to invest in inflation-indexed bonds or in short-term government.