
As inflation and interest rates increases, real income begins to fall. This contributes to falling consumption. The rise in interest rates discourages borrowing as mentioned above, but it is true for companies as well. The profits of companies may start to fall as wages and the cost of other inputs rising shrinks margins. Companies cut production to try to normalize supply and demand. This leads to falling capacity utilization. Firms freeze hiring and may reduce staff through attrition and layoffs to restore margins. Because borrowing is so expensive and because free cash flow is dropping due to decreased margins and profitability, firms cut back on capital expenditures. Inflation starts to fall.
This scenario is not good for the stock market. It would be desirable to become quite defensive. You would lower the beta of the portfolio to below 1. You would cut your allocation to stocks. You would move to defensive sectors of the economy that are less affected by downturns in the economy.
In circumstances like this, you would lengthen out the duration of your bond portfolio. This is a time to look at zero coupon bonds and other longer treasury bonds. You would let your floating rate notes mature or sell out of them. You want to lock in the highest interest rates possible for the longest time possible. This is a time to increase your allocation to bonds.







Comment Preview