The recent rapid drop in stock-bond anti-correlation from relatively very high levels to near zero was triggered mainly by prospects of stagflation in the U.S., a highly undesirable economic environment where bond prices collapse, stocks in the best case move sideways, unemployment is high and prices rise. Stagflation has high probability at this point but this does not mean it will eventually happen.
The question is: why has the rolling 120-day correlation between stock and bonds, as shown on the above (NYSEARCA:SPY) and TLT charts, suddenly risen fast to neutral territory after being negative for the last 3 years? An obvious reason is that lately stocks are correcting and bond prices are falling and thus the two are correlated. Then the next question is: how significant is this development and what does it mean for the future of the markets?
Falling, or sideways moving, stock prices and rising yields usually occur during stagflation periods. During the 1970s, as marked on the above chart that shows the correlation between S&P 500 index and the 10-Year Note yield, a multi-year stagflation period in the U.S. was caused by commodity price shocks that negatively affected economic output, propelled prices and interest rates higher and caused high level of unemployment. This has maybe confused some economists because at this point inflation is low and commodity prices are at relatively low levels. But the current shock has to do with the financial crisis and its ramifications. The FED, after an extensive period of quantitative easing, is now between a rock and a hard place. The real dilemma is not when to end QE because the economy is doing well, but whether the FED will be forced to face stagflation caused by rising yields and higher prices. But why stagflation and not deflation? The reason that deflation is no longer a problem is that output has been adjusted, both in U.S. and China, and lower prices due to over-supply is not the problem any longer. Actually, prospects of higher taxes so that those who produce finance the standard of living of those who cannot or do not want to produce have spooked investors and entrepreneurs both in the U.S. and around the world. Many think that there is no point in taking excessive risks to invest and devote a life to a new venture if the government is going to redistribute their wealth to others. Europeans obviously have not learned the lessons from the collapse of the Soviet Union and are thinking of excessive tax rates. But in the U.S., only the remote possibility of future higher taxes can spook the economy and produce undesirable effects that can last for several years.
How to protect wealth from the possibility of stagflation
Strategies to deal with stagflation are inherently longer-term and may involve investments in high-tech companies that will be part of the foundation of the next economic up cycle. However this is easier said than done. Identifying the future winners is a difficult task that can be accomplished only by very knowledgeable and competent analysts. For example, in the 1970s, investments in companies like Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) proved lucrative but there were many other companies in the same fields that did not survive. Thus, diversification of risk through a portfolio of investments is a prudent strategy. Then, investments in farmland and precious metals may prove to be a good hedge against inflation and rising prices. ETFs like VNQ and IYR may be good vehicles in the real-estate front and SLV, GLD and PPLT in the precious metal front but only as a potential hedge, in my opinion.
It is quite possible that the next economic up cycle will be founded on more automation and robotics and significant developments in the transportation industry, like high speed travel, electric cars, and space exploration and tourism. Again, identifying the key players in this area that will survive and dominate is a very difficult task that only very knowledgeable analysts can accomplish. The end of QE in the US will mark another worldwide round of wealth redistribution and investors should be prepared to navigate through such a difficult and hostile to personal wealth environment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Charts created with AmiBroker – advanced charting and technical analysis software.