Where is the Bottom?
June 23, 2022
The first half of 2022 has not been kind to investors. Following a period of “good” years in which investors have experienced above-average positive returns in many asset classes, virtually all asset classes this year have delivered considerable negative returns and there remains a high degree of uncertainty due to a number of lingering economic factors. Elevated inflation and rapidly rising interest rates are not only impacting the markets, but are having a direct impact on personal budgets as well.
It is understandable and natural for investor anxiety levels to be elevated during periods like this. A couple of questions that tend to arise are:
- What’s going on?
- Where is the bottom?
What’s Going On?
As mentioned, almost every asset class is firmly in negative territory so far this year. Fixed income markets have been impacted to a similar degree as equity markets, which has reduced its typical diversification benefits within a balanced portfolio.
So… what’s going on? There are a number of factors influencing the global economy and financial markets, but the key drivers can be boiled down to inflation and interest rates, which are very much interconnected in the current environment.
Inflation is the most significant root cause impacting markets at present. Inflation levels began to rise during 2021 and were expected to be predominantly “transitory”. In other words, it was determined that inflation had risen due to temporary supply chain issues resulting from the pandemic, and it was expected that inflation would revert back to normal levels within a relatively short time frame once these issues worked themselves out.
The emergence of the Omicron variant at the end of 2021 pushed many countries back into restrictive lockdowns – most notably China, which exports an immense amount of goods to countries around the world. Factory shutdowns and delayed shipments further strained the already weakened global supply chains. As demand for goods exceeded available supply in many industries, prices continued to rise.
The Russian invasion of Ukraine in 2022 also further stressed supply chains, but more notably impacted global energy prices. The prices of oil and fuel are currently at the highest levels in over a decade and well above long term averages. Higher fuel costs further contribute to inflation as companies pass on higher shipping costs to consumers.
The other notable factor that has contributed to the inflationary environment is the stimulative monetary and fiscal policy that was enacted in most countries during the pandemic. Short term interest rates were cut to near zero levels, quantitative easing programs pumped liquidity into the markets, and governments spent historic amounts of money on direct assistance programs to support citizens and businesses. These actions are largely credited with avoiding a depression-like scenario as global economies ground to a halt. As these actions increase economic activity and aggregate demand for goods and services, however, it also puts upward pressure on prices.
Central banks have now abandoned the term “transitory” when discussing inflation as it is clear that the underlying issues are persistent. The latest inflation readings for Canada and the U.S., as measured by the year-over-year change in each country’s Consumer Price Index (CPI), are 7.7% and 8.6%, respectively – the highest levels since the 70s/80s. Other developed countries are at comparable levels.
Current inflationary conditions are correspondingly having a major impact on interest rates. Interest rates have risen significantly this year as central banks have begun unwinding the stimulative monetary policies enacted during the pandemic. Central bank actions have been aggressive in an attempt to get inflation under control as higher interest rates are intended to reduce aggregate demand for goods and services, which in turn should alleviate inflation to an extent. It remains to be seen how effective these actions will be in light of supply chain and energy price shocks that central banks have no control over.
From an investment perspective, higher interest rates have a direct impact on bonds and other fixed income assets. Bond prices are inversely related to interest rates and, as a result, have experienced negative returns in this rapidly rising interest rate environment. That said, yields on fixed income assets have also risen significantly. This means that, although fixed income assets have performed negatively this year, the expected income and future return expectations from fixed income assets going forward have increased meaningfully.
Higher interest rates impact equity markets in a more indirect way. At the individual company level, higher interest rates increase the cost of borrowing which can pressure profit margins and slow new capital investments. Consumer spending may also experience a slowdown that ultimately impacts corporate profits. At the overall market level, higher interest rates can make equities less attractive on a relative basis compared to fixed income investments that offer lower risk and higher yields.
Interest rates are also a fundamental input to the calculations used in assessing the “intrinsic value” of a company. Estimated future cash flows are discounted back to the present based on prevailing interest rates. Higher interest rates decrease the present value of expected future cash flows and reduce intrinsic value estimates of a company as a result.
Expensive (from a valuation standpoint) technology related companies and other “growth” style investments, particularly in the U.S., that have been the market darlings in recent years have been some of the most negatively affected companies in 2022. Expensive valuations that were based predominantly on expected future growth have been repriced to reflect the new interest rate reality and shift in investor sentiment.
Quick Recap: 2022 (so far)
- High inflation has resulted in significantly higher interest rates in 2022.
- Higher interest rates have negatively affected fixed income assets and equity assets as a result.
- Expensive technology related companies and “growth” style investments have underperformed “value” style investments in this environment.
- Energy and commodity related companies have fared comparatively well due to higher underlying commodity prices.
Where is the Bottom?
It is natural for investors to want to avoid negative returns. The fear of losing hard-earned money is scary and can bring about great anxiety for many people. Studies from behavioural economists Amos Tversky and Daniel Kahneman have suggested that losses are twice as powerful, psychologically, as gains. This bias can cause investors to act irrationally and make poor investment decisions in an attempt to avoid short term portfolio declines.
With the benefit of historical data, it may seem easy to describe past market cycles as being predictable or “time-able” (getting out at the top and entering at the bottom). In practice, however, it is remarkably difficult to do so. Timing the market not only involves an accurate prediction of when to get out, but also when to get back in. A perfectly timed exit is not beneficial if the investor misses the re-entry point at the bottom. Given the fact that a sustained downward trending market (also known as a “bear market”) is only known with the benefit of hindsight, and is typically much shorter in length on average compared to a sustained upward trending market (“bull market”), the window of opportunity to perfectly “time the market” is small and the probability of success is low.
Trying to predict short term market movements is not a useful exercise. The fact that markets experience volatility and periodic downward trend cycles is the reason why an investment portfolio can be expected to offer higher returns over the long term compared to “safe” assets like cash or guaranteed investment certificates (GICs). Investors receive a “risk premium” that compensates investors over time for enduring this volatility and cyclicality.
To answer the question – no one knows where the bottom is, and you should be skeptical of anyone who tells you they do. Perhaps the bottom has been reached already and we just don’t know it yet without the benefit of hindsight. What we do know is that markets are cyclical over time and unpredictable in the short term, and as a result are expected to offer positive returns over the long term for patient and disciplined investors.
“Investing is Simple, But not Easy”
As Warren Buffet famously noted – “investing is simple, but not easy”. It’s simple because investors can achieve a high probability of success over time given a suitable investment portfolio, a systematic rebalancing process, and a well-thought-out financial plan with the discipline to stick to it. It’s not easy because our emotions tend to interfere along the way.
As always, Quadrant remains diligent and disciplined in the management of client portfolios. In addition, our external asset class managers continue to manage risk and seek to add value through active security selection, sector allocation, and diversification.
While it may not be easy at times, we are confident that disciplined investors who remain dedicated to their investment process through the ups and downs will be well-served over time. Business and market cycles will continue to roll on and the capital markets will remain a fundamental building block in creating and preserving wealth.
Disciplined. Compassionate. Effective.
Quadrant Private Wealth is an independent, comprehensive, integrated wealth management firm committed to your financial well-being and peace of mind. We take the time to understand your complete financial picture. We tie all of your information together, including tax planning, to paint a picture of what your financial future could look like. And we aim to earn your complete confidence in the process.
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