If you compare the global pandemic to an earthquake, today we are experiencing several major aftershocks.
Inflation is rocking almost every country in 2022. In response, central banks around the world are quickly raising interest rates. This abrupt increase in rates has impacted all investment assets negatively. Markets have been extremely volatile this year, and most indexes are now in bear territory.
Add to that a Russia-Ukraine war, another major COVID lockdown in China, energy shortages everywhere, and talk of a global recession.
All this reminds me of the saying, “May you live in interesting times.”
I’m sure I’m not alone in hoping that the “boring times” come back real soon.
With all that’s going on, I think it’s important to review what’s happened in the markets so far this year. After that, we can look at some perspectives and strategies to help keep your financial plan on track and moving forward.
Although things look grim at the moment, there are positive signs on the horizon. In fact, several opportunities are beginning to emerge for long-term investors.
Inflation is back, with a vengeance
First, let’s cover inflation. As most shoppers know, prices have shot up this year for most goods and services. Things like food, gas, rent, mortgages, haircuts, hotel rooms etc. are all significantly more expensive than they were a year ago.
Why are prices rising in 2022? COVID is a big reason.
To recap, COVID-19 was declared a global pandemic in early 2020. To stop the spread of the virus, the world economy went into several lockdowns. Many sectors were shut down and activities were limited during this time. To help sidelined workers and businesses, governments introduced many wage supports, grants and tax credits.
Limited spending and government support led to a spike in personal savings rates. In Canada, the household savings rate rose to 13.1% of disposable income in 2021 compared to 5.1% in 2020.
When the economy started to reopen, much of those extra savings were put to use. Households began to “catch-up” on their spending, which led to a spike in demand for all types of goods and services. High demand is one reason why prices are rising today.
There are also supply-side factors at play. Supply chains were disrupted by the pandemic, which increased the cost of materials. (Just ask anyone who is trying to complete a home renovation, or build a deck). Energy costs are rising, too, and that’s being exacerbated by the Russia-Ukraine war. Reduced supply is another reason why prices are rising.
We also need to consider the easy-money policies used during the pandemic. To keep the economy afloat during the COVID-19 lockdowns, governments implemented several fiscal policies (i.e. wage supports, tax breaks). For their part, central banks dropped interest rates to near zero and kept them there for almost two years. Central banks also purchased billions of dollars worth of assets (known as quantitative easing).
Today, the threat from COVID-19 is easing. Now these three factors (high demand, reduced supply, easy-money policies) are combining to push prices strongly upwards in 2022.
Canada’s inflation rate was 7.0% in August 2022. That’s down from 7.6% in July, and 8.1% in June. But overall inflation is still too high right now.
Now governments and central banks are reversing course to fight the latest surge of inflation.
Interest rates are now rising
Why is high inflation bad? Because it decreases the value of money. In other words, when prices go up, your money doesn’t buy as much.
Central banks try to keep inflation low, stable and predictable. That helps money keep its value. It also makes it easier for people to plan how, when and where they spend.
Many economists agree that a small amount of inflation is good for economic growth. That’s why central banks like the Bank of Canada and The Federal Reserve (U.S.) have an inflation target of 2%.
However, inflation right now is well above 2% in most countries. So central banks are quickly raising interest rates to try to bring inflation down. Higher interest rates increase the cost of borrowing money, which typically reduces demand and slows down price increases.
The Bank of Canada has raised interest rates five times since March 2022, moving the benchmark policy rate to 3.25% from 0.25%. It’s one of the fastest rate hike cycles on record.
Increasing interest rates is the most common way central banks fight inflation. But like most medicines, this treatment has some side-effects.
Right now, rising interest rates are having a negative impact on almost all assets.
All assets are adjusting to higher interest rates
All assets are worth less when interest rates rise. Why? Because interest rates are like gravity on asset prices: When interest rates fall, asset prices tend to float higher. And when interest rates rise, asset prices tend to come back down to earth.
“Interest rates are at the core of every asset in the universe.” said Charlie McElligott, managing director at Nomura, a financial services company.
Here’s an example: When interest rates fell to historic lows during the pandemic, the price for homes in Canada skyrocketed. In fact, the price for most assets (stocks, bonds, real estate, artwork, Bitcoin etc.) went up during the pandemic as interest rates fell.
Now the reverse is happening: Interest rates are rising, asset prices are falling. Continuing with our example, the average price for a residential home in Canada has now dropped 20% from its peak in February 2022, according to the Canadian Real Estate Association (CREA). Most investment assets this year have seen similar declines.
Source: TD Asset Management
To summarize the last two years: The pandemic hit in 2020. Easy money policies were used to stabilize the locked-down economy. As the pandemic eased, economies began to reopen. A combination of high demand, low supply and easy money led to a spike in inflation. Interest rates are now rising to fight inflation. All asset prices are adjusting to higher interest rates.
Where do we go from here?
OK. Enough economic talk. The question many people have is: Where do we go from here?
Let’s face it. Nobody likes seeing the value of their hard-earned assets go down, be it stocks, bonds, home prices etc.
Investing often takes you on an emotional roller-coaster ride. When markets rise, investors feel excitement and euphoria. When markets fall, investors feel anxious and fearful. Those feelings are 100% normal.
Source: Russell Investments
But it’s important to understand that those emotions can get you into trouble. Many investors consistently do the wrong thing at the wrong time. It’s almost like the human brain is wired wrong when it comes to making money decisions.
The golden rule of investing is always, “Buy low, sell high.” There’s no emotion in that rule. It’s just pure math. But without proper guidance, many investors often do the opposite.
For example, many investors piled into cryptocurrencies and non fungible tokens (NFTs) during the second half of 2021. These new technology-based assets were market darlings back then. Prices were rising. Excitement was high. So many people invested more money into crypto and NFTs at even higher prices.
Well that popularity contest is now over. Cryptocurrencies have crashed. NFTs have crashed. And many do-it-yourself investors are now feeling the sting of improper money management.
Investors can behave irrationally in the short term. But over the full market cycle, value and fundamentals tend to matter.
That’s why the greatest investor of all-time Warren Buffett says “Be fearful when others are greedy and greedy when others are fearful.”
Focusing on what you can control is how you stay on track with your goals. So let’s look at some perspectives and strategies to help keep you on the right path forward.
1) Take a long-term view
I get this question all the time: Is now a good time to invest?
And right now, with inflation running at multi-decade highs, a Russia-Ukraine war, rising interest rates, and the risk of new COVID-19 variants, it seems like there are many reasons not to invest.
But there will always be a reason not to invest. No matter what time frame you look at, there’s always something going on in the world that could threaten your investment plan.
The chart below looks at the largest stock market index (the S&P 500) over the past 90 years. While past performance doesn’t guarantee future returns, it’s helpful to get some historical perspective.
As you can see, everything we are experiencing now has happened in the past: wars, virus outbreaks, periods of high inflation. All those past events are short blips over the long-term positive trend in the market.
Source: Russell Investments
Here’s another perspective: Let’s look at the S&P 500 index from 1926 to 2021, and stack the years according to their return. For example, all the years with a plus 20% return are stacked in one pile, all the years with a minus 20% are stacked in another pile, as so on.
As you can see in the chart below, the S&P 500 has had far more positive years than negative years. In fact, the market has produced a positive return 74% of the time since 1926. Those are pretty good odds.
Source: Russell Investments
2) Stay invested
It’s normal to feel anxious when markets get choppy. You may even feel tempted to pull money out of your portfolio and move it to cash until things calm down. But you need to realize that’s an emotional reaction that’s trying to trip you up.
Nobody can predict what the market will do in the short run. Not even Warren Buffett knows where the market will be a week, a month, or even a year from now.
It’s important to know that market downturns are relatively short-living and typically followed by strong rallies that more than make up for any previous losses. Trying to “time” the market is impossible and could cost you. Missing the best 10 days over a 10-year period has a significant impact on returns, as the chart below shows.
Source: Russell Investments
Staying in the market also allows you to take advantage of the power of compounding. Time in the market (as opposed to market timing) is the best way to harness the power of compounding. Even a small nest egg can grow into a significant amount over the years as your investment gains build.
3) Recent volatility is creating opportunities
Investments can often become mispriced during volatile markets. With rate hikes coming fast and furious, market participants are rapidly trying to re-value assets, and they can often get things wrong. This can be an opportunity for those investors with a long enough time horizon and cash on the sidelines to deploy.
Let’s look at the largest stock market again. This is the ninth time the S&P 500 is down more than 25% since 1950. History provides no guarantees for the future, but buying stocks when they’re down big tends to produce positive outcomes for long-term investors.
Source: Ben Carlson, A Wealth of Common Sense blog
There’s also positive news for bonds. According to a recent report from National Bank, bonds are showing a significant improvement in their five-year return expectations. Yields for bonds are nearing levels not seen in more than a decade. Yields are also greater than expected inflation over the next five years, even after adjusting inflation upward.
By diversifying your portfolio across different asset classes, you can achieve greater consistency in returns, and ultimately protect yourself against market volatility.
Conclusion
Feeling anxious when the stock market drops is a natural response to volatility. That’s why it’s important to stay committed to your long-term plan and resist making emotional investment decisions.
A financial advisor is there to listen and provide guidance. They can help you keep your emotions in check and your investments on course during the ups and downs of the market.
About the Author:
Paul Carvalho is an independent financial advisor based in Hamilton, Ontario. He helps families and individuals with investments, life insurance and retirement planning.
This information has been prepared by Paul Carvalho who is an Investment Fund Advisor for Investia Financial Services Inc., and does not necessarily reflect the opinion of Investia. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Fund Advisor can open accounts only in the provinces in which they are registered.