By Dhara Ranasinghe

LONDON, (Reuters) – Investors are increasingly concerned about the rise in inflation and the central bank’s policy. The traditional market strategy on how to respond to military crises is now obsolete.

Wall Street saw a slide of 5% last month due to unease about Russia’s military buildup close to the Ukraine border. But top-rated bonds of government and gold were not among the beneficiaries. These assets are known to rise when war or political instability threatens.

U.S. bonds and German bonds, considered to be the most secure assets among all, saw their worst month in 2021. Yields jumped 30 and 20 basis point respectively due to inflation and higher rates. Gold fell 2%.

(Graphic: Inflation-focused safe-havens fail to benefit from Ukraine woes: https://fingfx.thomsonreuters.com/gfx/mkt/klpykmdzlpg/Ukrainewoes0101.PNG)

Stocks and bonds rarely fall simultaneously. John Briggs is the global head for desk strategy at NatWest Markets. This has occurred in approximately 14% of the 35-month period since 2000, according to John Briggs.

The inverted correlation between bonds and equities has been used by investors for decades to help protect returns when times are tough. One traditional strategy is a 60/40 portfolio.

Briggs states that investors should entertain the possibility of markets reacting differently to central bank responses to rising inflation.

The old correlations may no longer hold if there is a significant deterioration of Ukraine’s situation.

The muted response of markets to Russian sabre-rattling (it denies that it intends to invade its neighbor) may not surprise those who observe how recent risks events such as missile launches and attacks on oil facilities in the Gulf have only had a temporary impact on investor behaviour.

The difference this time around is that inflation has been subdued over the past decades and is now running high in many countries. Inflation fears would be further fueled by Russia’s conflict, which could increase oil and food costs.

John Flahive is the head of Fixed Income Investments at BNY Mellon Wealth Management (NYSE:). He stated that market volatility has left clients “a bit unsettled”.

He stated that if the equity market is down 10% you would expect to see some quality flight in higher-quality fixed income security. But that’s not what’s happening.

You wake up at January’s end and you realize that not many of the portfolio portions have been insulation, so everything is red.

The typical 60:40 portfolio fell 3.77% in January, following a December increase of 2.34%, according to Vincent Chaigneau (MI:) Investments head, but is still up 5.3% since January 2021.

(Graphic: Bonds and equities in the red so far this year: https://fingfx.thomsonreuters.com/gfx/mkt/egpbklawlvq/bonds0202.PNG)

POLICYMAKER HEADADACHE

The military threat presents a problem for policymakers who are trying to end stimulus from the pandemic and control inflation.

In March the Federal Reserve is expected to raise rates. The Bank of England will hike its rate for the second consecutive month on Thursday. Record eurozone inflation may force the European Central Bank into a reassessment of whether price pressures in the short term.

The question here is whether the looming political risks may be too low on investors’ radars for those who are obsessed with inflation. What options are available to investors if the bond hedge that has been tried and true fails?

A portfolio manager stated that clients are increasingly exposed to high-quality corporate debt as they see it as a steady source of return.

Additionally, investors might be tempted to invest in the U.S. dollar or other assets during times of high geopolitical tension. These investments tend to perform better than others.

Amundi Asset Management advises that investors keep their risk neutral, taking into account constructive earnings revisions across many sectors. But they must be open to reducing risk in the event of a material deterioration.

REPRICING

Safe-haven bonds may be rediscovered if tensions rise and the markets depreciate expectations about growth and the response of the monetary authorities.

Europe’s dependence upon Russian gas renders it especially vulnerable.

(Graphic: on a tear: https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrjeanpm/Brentcrude0102.PNG)

BofA analysts predict that Brent crude would rise by around 30% from its current level and prices will jump 2000% in extreme scenarios. The bank could raise its forecast for headline Euro area inflation to 4% instead of 3% this year, while reducing its current GDP forecast at 3.6% by 50 base points. That leaves the ECB little room for raising rates.

Randy Kroszner is a former Fed governor and economic professor at University of Chicago Booth School of Business. Ukraine may prove to be a test case in geopolitical terms for the markets.

He said, “That’s one the wildcards we haven’t had recently — moving from cold war to hot war that could include Russia and NATO.”