What has changed for investors?

1.????Lower fixed income returns

For the last 40 years up to 2021, bonds (especially long duration) have provided equity-like returns with lower volatility and lower drawdowns (so better risk-adjusted performances)

2.????But that period has ended, so expect greater volatility in “safe” assets

Current drawdown in long-duration treasuries is around 40% and the worst ever, but post-GFC there have been already other periods of double-digit declines.

3.????Equity/bond correlation flips from negative to positive

The negative correlation between equity and fixed income is a feature of the last two decades, while it had been positive from the 1960s to late 1990s. Going forward, the correlation will be a function of the (new?) inflation regime.

A thoughtful chart (valid at least for the US): when inflation is less than 2.5%, the equity/bond correlation is negative or close to zero (last 20 years); when inflation is greater than 2.5%, it suddenly flips to positive (the four decades before the new millennium).

4.????Leverage is way less attractive

Over the last 40 years, leverage has been used not to finance investments in capex/tangible assets, but mostly to enhance returns in the financial sector. With rates constantly going down, it was a good trade (with the exception of 2008). But with rates now moving in the opposite direction, leverage is going to be very painful.

5.????Equity leadership will change

There is no straightforward relationship between the level of interest rates and equity valuations.

Since 2014 the outperformance of US equity markets has not been driven by QE and monetary policies, but rather by the strength of US equity earnings. In a low rate environment, it is more difficult to grow sales and/or profits: the US markets managed to do it (although concentrated in the few top tech companies) and have been rewarded accordingly.

But when rates rise, the opposite will happen (de-rating): so it is possible that the “market leadership” will change again from tech to other sectors. ?

6.????Less broad-based asset returns (less beta)

Beta will be more difficult to get going forward. Using the standard 60/40 portfolio, in the past there have been 3 periods of “beta drought”, and all were associated with high inflation (the fourth period was rather characterised by excessive valuations, which are also present today).