Written by Tom Stanley, Investment Adviser, 27 April 2022
Investing Through Thick and Thin: War, Rate Hikes, Inflation & Getting Sentimental
The landscape of investment and advice has changed materially over the last few decades. KiwiSaver and retail p* Apologies for a ‘heavier’ note this month, sometimes we need to dig a little deeper – please stick with it – if you have any questions, please pick up the phone (021 194 7672) *
I hope the back-to-back long weekends here in New Zealand have given you time to reset and recharge the batteries. Unfortunately my household was finally hit with COVID, so our Easter plans were a little disrupted… Fortunately all are recovering well, but this COVID disruption got me thinking. Yes, Q1 2022 has seen Omicron spread across New Zealand, but it has also left many investors feeling their plans are ‘disrupted’. Sentiment and returns have taken a hit amongst an onslaught of disturbing headlines. This month, my note acknowledges the current uncertainty, and seeks to provide some clarity and direction, should you be compelled to take action.
In the first 3 months of this year, we have seen markets pull back, and commodity and energy prices spike off the back of the Russia/Ukraine war. This conflict spurred on already heightened inflation fears with inflation hitting 30 year highs in NZ, and 40 year highs in the US. As a result, central banks have started hiking interest rates faster than you can say ‘inflation is transitory’ (their go-to phrase from 2021 to talk down inflation risks). In fact, as recently as last week, the US reserve bank (Federal Reserve) has ramped up market expectations for big interest rate hikes of up to 0.75% (75 basis points) in May and June – these hikes would have been considered unthinkable (and market crippling) just two months ago.
|With higher inflation expectations and rate hikes materialising fast, a global recession indicator also flashed at the end of March – the UST yield curve inverted (well, part of it, the 10/2 spread did). In short, this means the 10 year yield (interest rate) fell below that of the 2 year yield on US Treasury Bonds. In practical terms, many of us are familiar with the idea of a 5 year term on our mortgage being more expensive than a 1 year term, think of this situation as being able to ‘lock in’ a cheaper mortgage for the next 10 years than you can for the next 2 years – a strange dynamic! We won’t dive into the details of ‘yield curve inversion’ in this note, but the 10/2 term spread inverting in the world’s largest economy is important, as it has a good (not perfect) track record for predicting recession, having inverted prior to every recession back to the 1950s (with one false signal). Unfortunately, this ‘signal’ is not definitive for stocks and other risk assets. The inversion is generally followed by a recession 6 months to 2 years later but there is no way to know in advance when. Furthermore, stock performance after an inversion is mixed but with a positive bias – Some statistics:|
|– The 10/2 spread has inverted 6 times since 1978 and the average US stock market return 1 year later is +13.4%.|
– 1 year returns for 5 of the 6 periods were positive (the exception was the 2000 when US stocks were down -2.53% one year later).
|As I write this note, there is great uncertainty, but limited concrete data or evidence indicating an imminent recession. |
Recession may not be imminent, but I would be remiss to gloss over the pain of Q1 2022. As you will likely have seen or heard, stock and bond markets have BOTH been pressured lower at the same time in 2022 (an uncommon event). At the time of writing, the main global equity benchmark (MCSI World) has dropped more than -11% year-to-date, while the traditional safe haven of the bond market has been hit equally as hard, with the Bloomberg Aggregate Bond Index similarly down more than -10% – the bond markets worst quarter since 1980! Painfully, this means the classic ‘Balanced’ 60% stocks / 40% bonds portfolio has been just as good as owning an ‘Aggressive’ portfolio of 100% stocks year to date. As many of you may have seen, owning bonds as a defensive asset and diversifier as a hedge against a bad stock market, has not worked out this year.
With the above context, it probably isn’t news that people are not exactly thrilled with the current state of the economy. A lot of that has to do with inflation, but also global Reserve Bank’s responses (aggressive interest rate rises). This negative view of the economy is evident in the often cited ‘University of Michigan Survey of Consumer Sentiment’. Sentiment has recently been trending lower, hitting 59.4 in March of this year. Per the chart below, readings that low have only ever been recorded during recession – Dates with readings this low were February 1975 (57.6), May 1980 (53.6), April 1982 (64.7), December 1990 (65.1), December 2008 (57.7), and October 2011 (58.7)…
The lowest sentiment reading in 2020 during the worst of COVID was 74.1 in June 2020 – indicating sentiment was more positive than it is now in the grips of a global pandemic!
But what does a low reading on consumer sentiment actually mean to an investor? Forget whether the survey provides any information about the future economy; what does it mean for markets? While the dates mentioned above were not all ideal times to buy stocks, the downside risk on most of those dates was pretty minimal. Some of them were great – not good – times to buy. In other words, consumer sentiment, which is very negative right now, is a contrarian indicator for investors. Now may not be the time to go on an ‘all-in’ buying spree, and I am not saying a ‘bounce back’ is imminent, but it is worth noting – Negativity about the economy is pervasive across the globe, and is not supported by the economic statistics, at least for now.
What is the main risk for you now?
Breaking from your plan, responding emotionally and making decisions that are inconsistent with your strategy and investment time horizon.
What does that look like?
One example is switching to a lower risk fund to ‘stop the pain’ regardless of your investment time horizon – As I have shown above, investors across the board (conservative and aggressive alike) have been hurt by markets this year. The problem with ‘switching’ funds to ‘stop the pain’ is that you lock-in paper losses, and risk missing out on any ‘bounce back’. How easy it is to ‘miss out’ on a bounce back is best shown by the below chart from Consilium – Share market gains are not evenly spread throughout the year; they can be concentrated into only one or two months. In fact, on average the best month of the year each year accounts for almost the entire additional return of shares vs term deposits – unfortunately, we don’t ever know when that month will come!
Another example is pausing your regular contributions because markets might fall further – This is the idea of trying to ‘time the market’ and even professional investors have a patchy track record in this space. Maintaining your contributions into market weakness may feel uncomfortable, but markets falling actually offers you an opportunity to invest at a discount. The primary benefit of regular contributions or ‘dollar cost averaging’ is to take the guesswork and emotion out of investing and portfolio management.
Yes, there is a lot to be nervous about today with war, interest rate hikes, a slowing Chinese economy, rapidly rising prices (especially food and energy prices), and super negative consumers. The fund managers you are invested with will be weighing up all of the above and making tactical changes for you, but making big changes to your investment strategy requires special consideration of your situation. I would love to tell you where markets move from here, but my crystal ball is cracked, so we’ll just have to focus on what we can control and wait and see how things unfold.
So, what can I control and what actions can I take?
- Still working & building your wealth?
- Nearing retirement? (Retiring in less than 5 years)
- Its time to review your plan, contributions, and talk retirement scenarios – Reach out now.
- Retired and drawing from your investments?
- Consider suspending your withdrawals from your investments and drawing on cash reserves – Fully invested? Reach out and lets review your situation.
- Making a large withdrawal from your investments soon? (e.g. KiwiSaver First Home withdrawal).
Your rate of contribution and capital preservation are the most critical factors. If your withdrawal is imminent, your timeframe limits your ability to leverage ‘compounding’ of returns. If you are in a ‘higher risk’ growth or aggressive fund and withdrawing funds soon, let’s talk.
If you have any questions, please contact me using details below.