For almost a year, ever since America’s stockmarket peaked on January 3rd, investors have been craning their necks, looking for the bottom. Will the most recent trough, halfway through October, turn out to have been it? More importantly, bottom or not, what trends will shape returns going forward? Even at present levels, the slump in markets around the world this year has been painful. MSCI’s broadest index of global equities is down by 18%, as is the S&P 500 index of big American firms. It is not just shares that have suffered. More speculative assets, naturally, have been bludgeoned far harder: the market value of all cryptocurrencies, which surged to nearly $3trn in 2021, has fallen to $840bn. Supposedly safer assets have not escaped the rout, either. The indices compiled by Bloomberg, a data provider, of global, European and emerging-market bonds have all dropped by 15%; the American equivalent by 11%. TRENDING STORIES See All Premium ‘What if Ambani or Adani does this!' Elon Musk condemne . . . Premium Recent left-wing triumphs in Latin America may prove sh . . . Premium DSP MF buys more shares of these 6 Adani stocks in Janu . . . Premium Income tax raid at BBC offices day 2: Broadcaster issue . . . The breadth of losses is even more striking than the depth. In particular, the “60/40 portfolio", comprising 60% stocks and 40% bonds, a popular choice for investors seeking a good return without running big risks, has performed appallingly. Evan Brown and Louis Finney of the asset-management arm of ubs, a Swiss bank, calculate that, as of mid-October, a 60/40 portfolio of American equities and Treasuries had had its worst year since 1937. Typically, portfolios allocating more to bonds and less to equities are considered less risky. But losses on bonds have been so steep this year, says Alex Funk of Schroders, another asset manager, that this rule of thumb has not always held. Other presumed safe havens have also offered little shelter. Gold, seen by some as a hedge not just against the vagaries of financial markets, but also inflation, has fallen by 3%. The Japanese yen started the year at 115 to the dollar and is now 136. Well-timed bets on commodities, many of whose prices were supercharged by Russia’s invasion of Ukraine in February, would have paid off handsomely. Otherwise, investors have had startlingly few places to hide (see chart 1). View Full Image (The Economist) Share Via The plunging markets are the result of a decades-old macroeconomic regime falling apart. High inflation, not seen in the rich world since the 1980s, is back, which in turn has brought to an end ten years of near-zero interest rates. As a result, the rule book of investing is being rewritten. Protecting portfolios from inflation, once a peripheral concern, is now a prime consideration. Rising government-bond yields, meanwhile, make riskier assets less desirable. In particular, private markets (as opposed to standardised investments traded on exchanges), which expanded massively during the years when decent returns were hard to find, face an uncertain future now that they are not. Before this year, as bond yields grew ever more anaemic, the desperation of yield-hungry investors was encapsulated by the acronym tina: there is no alternative (to riskier assets such as equities). This approach helped to propel the world’s stockmarkets on a rampaging run. From its low point in 2009 to its peak at the end of 2021, the S&P 500 rose by 600%. In addition, the TINA mentality drove many investors to buy more obscure or illiquid assets in the hope of earning halfway decent returns. Private-equity funds have been prolific investors in unlisted companies ever since the buy-out boom of the 1980s. The typical “leveraged buy-out" involved buying a company mainly with borrowed money, parking the debt on its balance-sheet and selling it on. The dirt-cheap loans available after the financial crisis lit a rocket under the industry. Private markets around the world—the lion’s share being private equity, but also including property, infrastructure and private lending—quadrupled in size, to more than $10trn. Big private-equity firms created listed funds of unlisted firms, to lure in retail investors. But it was institutional investors that were especially enthusiastic: private equity and property came to comprise almost a fifth of American public pension funds’ portfolios. MINT PREMIUM See All Premium Indian history needs to be kept free of politics Premium State-run banks must not repeat their lending errors of . . . Premium Global stocks: Small investors may face brunt of 20% TCS Premium Why it’s too early to claim victory in our inflation fight The monetary backdrop that drove those trends has now changed dramatically. Though inflation in America peaked in June, it still stands at 7. 7%. Elsewhere things are worse: in Britain prices are 11. 1% higher than they were a year ago, and in the euro area the rise is 10%. The IMF forecasts a global inflation rate of 9. 1% over the course of 2022. As a result, markets expect the Federal Reserve to raise interest rates to 5% in 2023, and the Bank of England to lift them to more than 4. 5%. What is more, both central banks have started to unwind the huge holdings of government bonds they built up in the wake of the financial crisis (quantitative tightening, in the jargon). The intention of the purchases was to hold down long-term interest rates; the sales should have the opposite effect. This year’s carnage in the markets is the natural outcome of these changes. Inflation erodes the value both of the interest payments on bonds and of the principal. At the same time, rising interest rates drive bond prices down, to align their yields with prevailing rates. If inflation and interest rates were increasing because of runaway economic growth, shares might also have risen in expectation of higher earnings. But instead prices and rates are rising because of a commodities shock, supply-chain snarls and labour shortages that threaten corporate profits, too. That is why the hedging relationship that underpins the 60/40 portfolio has fallen apart. Rising yields on bonds simply make more volatile equities less attractive by comparison, so the prices of both assets have fallen at the same time. When the dust finally settles, it will reveal a landscape that is likely to have changed for good. Though markets expect interest rates to fall after a peak next year, the odds that they will collapse back to next-to-nothing seem slim (see chart 2). That is because inflation is likely to be hard to tame. Nearly two years of it have raised expectations of price rises, which can be self-fulfilling. Tight labour markets in many countries will drive wages up, providing a further push. Unrelenting demands on government spending—from ageing populations to an ever-growing expectation that states will shield people and companies from economic storms—may also help elevate interest rates and propel inflation. Taken together, these forces will reshape investors’ portfolios and alter the returns they can expect. View Full Image (The Economist) Share Via Start with inflation. Simona Paravani of BlackRock, an asset manager, does not expect it to return to the “rock’n’roll" levels of the 1970s, when it spent two long spells in double digits. But even if it soon settles down to an average in the low single figures, it would still be more elevated than it has been since the financial crisis. That makes building inflation-resistant investment portfolios more important than it has been in decades. Fortunately, that is easier than it used to be. Commodities, as a frequent source of inflation, also provide a good means to hedge against it. They are now substantially more “financialised" than they were in the 1970s, meaning that they have deep and liquid futures markets. That allows investors to acquire exposure to them without having to own any actual barrels of oil or bushels of wheat. Other assets can also provide protection from rising prices. Blake Hutcheson, the chief executive of OMERS, a large Canadian pension scheme, describes how his fund spent years building up big holdings in infrastructure and property. The revenues from such investments, in the form of rents and usage fees, tend to rise with inflation. “It always felt like low inflation and low interest rates were an aberration," says Mr Hutcheson. “We’ve been preparing for a day that looks like today. " The end of ultra-low interest rates has more far-reaching consequences. The increase in the “risk-free" rate “affects how you think about private assets, equities, bonds, credit, everything", says Schroders’ Mr Funk, by raising the hurdle rate against which all other returns are measured. TINA is dead, and has been succeeded by TARA: “there are real alternatives". Or, as Raj Mody of PwC, a consultancy, puts it, “If you can get 4% on government bonds, is 7% on private assets enough?" A reckoning is thus due over whether the more exotic and less liquid assets snapped up during the low-yield years are still worth what investors paid for them. It will be a big one. Private-equity funds and their cousins, private-credit funds, which raise money from investors to make loans, have become driving forces in corporate dealmaking. Leveraged buy-outs amounted to $1. 2trn in 2021, dwarfing the previous peak of $800bn in 2006. Private-equity deals accounted for a fifth of the value of all mergers and acquisitions. The market for private credit, often used to fund such deals, ballooned to over $1trn. That is more than twice its level in 2015 and only slightly less than the value of big loans made directly by large financial institutions. Big investors such as university endowments and sovereign-wealth funds have loaded up on private assets like never before. A creaking lever Can they keep their appeal now that rising government-bond yields have resurrected the alternatives? For leveraged buy-outs, which by definition are extremely sensitive to the cost of borrowing, the answer is almost certainly no. Scarcer, more expensive debt makes such deals harder to finance and less attractive to complete, as higher interest payments eat into prospective returns. Higher rates also diminish the value of the companies such funds already own, given their high levels of debt. Elsewhere the picture is more mixed. Private loans tend to have floating interest rates. That means that, unlike bonds, on which the interest is usually fixed, their value grows as rates rise. Many funds specialise in distressed companies, of which there will be plenty as debt becomes more expensive to service. Institutional investors often feel that the stronger oversight and influence that comes with private investments, as compared to public ones, gives them an edge. Yet the raised hurdle rate is inescapable. Private investors who buy a toll road, wind farm or office block are deliberately taking more risk than they would if they bought government bonds instead. Rich-world countries are very unlikely to default on their debt, but infrastructure and property can cost more to build than expected or yield less profit than projected. This risk is worth taking if investors are compensated by a better rate of return. The climb in risk-free rates therefore means private assets, too, need to offer higher returns if they are to stay attractive. Squeezing more revenue out of the assets will be tricky in a slowing economy. But the only alternative means to realise higher returns, selling the assets for a higher-than-expected price, is even more implausible given already dizzyingly high valuations. In all likelihood, many private assets face sharp write-downs in value. It is often up to the fund that manages the assets to value them. Managers are naturally reluctant to mark them down. In the first three quarters of this year, for instance, Lincoln International, a bank, reckons that private-equity funds globally marked up the value of the firms they own by 3. 2%, even as the s&p 500 shed 22. 3%. Such foot-dragging, however, will lead to lacklustre returns in the years ahead, as assets with unrealistic valuations prove difficult or impossible to sell for a profit. Many institutional investors have invested too deeply in private markets to unwind their holdings quickly. The scope for disappointment is high. In property, it is not just big institutional investors that are being hammered by rising interest rates. The same cheap and easy borrowing that lured them into private markets in the 2010s also pushed house prices ever higher. During the pandemic even lower rates and, for some, stimulus cheques, supercharged that trend. Now these drivers are going into reverse. More expensive mortgages limit how much buyers can borrow, causing their purchasing power to shrink. Like private-equity managers, home-owners are loth to acknowledge that their property may be worth less than they paid for it, making them unwilling to sell and causing transactions to dwindle. Yet across much of the rich world, a housing slump has already begun. Higher risk-free rates also change the types of company prized by investors. During the TINA years “growth" stocks, whose value depends on the promise of spectacular profits in the future, stormed ahead of their “value" counterparts, which offer steady income but less scope for growth. But as interest rates rise, they erode the present-day value of future earnings, making growth stocks less appealing. When the interest rate is just 1%, $91 deposited in the bank will be worth $100 in ten years’ time. Put another way, $100 in ten years’ time is worth $91 today. But when the interest rate is 5%, it takes only $61 to generate $100 in a decade. So $100 in ten years’ time is worth just $61 today. That makes future growth much less valuable, and immediate profits much more so. As stockmarkets have tumbled, therefore, growth stocks have performed especially poorly (see chart 3). View Full Image (The Economist) Share Via The same logic diminishes the investment case for startups and nascent firms, which by definition will earn the lion’s share of their profits in the future (if they prove successful at all). Higher rates diminish the value of future profits relative to current ones. For a firm whose profits are projected to remain stable indefinitely, less than a tenth of the present value of its future earnings comes from the first ten years when the interest rate is 1%. At 5%, around two-fifths does. Sure enough, the type of startup that draws the most interest from investors has changed, says an experienced venture capitalist. Whereas those that expanded the fas