Staying the Course
The first quarter of 2022 reminded investors that volatility, inflation, and geopolitical risk come with the territory when investing in global markets:
On 24 February, Russia invaded Ukraine, triggering Europe’s largest refugee crisis since World War II and causing more than 4.6 million Ukrainians to flee the country with an estimated 7.1 million displaced as of April.
U.S. inflation accelerated to 8.5% in March, marking a four-decade high and hitting levels not seen since 1981. Petrol prices rose 48% over the year, accounting for half the rise. (This led to electric vehicles accounting for 1 in every 20 new cars sold in the US in March).
Australian inflation for the year to 31 March 2022 was 5.1%, and 2.1% in the March quarter. The most significant prices rises were petrol (+11%) and rising construction costs for new homes (+5.7%).
The S&P 500 has fallen 13% since the start of 2022, and the Australian stockmarket is down 4.6%. (Both indices remain flat or slightly positive over the past 12 months).
The U.S Federal Reserve approved its first interest rate hike in more than three years of 0.25%, and indicated an aggressive path ahead to try and control rising prices.
This time period brings with it a humbling perspective and we pause to acknowledge the true human cost of the events unfolding in Eastern Europe. The headlines and stories are heart-wrenching, and the number of lives lost will undoubtedly climb. It is normal to feel anxious or nervous during a time like this. It is also natural to question what will happen to the markets, and to wonder how our own lives will be impacted. And yet, we stay the course.
Volatility
The U.S S&P 500 stock index started the year at 4,796.56, dropping to 4,326.51 on 27 January, bumping back up to 4,589.38 on 2 February, and fluctuating between -2.82% to -12.5% in the two months since. This is volatility.
The graph below shows the performance of the Australian stockmarket over the past 12 months:
Volatility is the measure of the up and down movements of the market. The lower the volatility, the smoother the ride. The higher the volatility, the more it feels like a roller coaster you’d like to exit. This random, roller coaster behaviour of the stock market over a period of days, weeks, or months, is largely driven by uncertainty in the economic and business outlook. In this particular case much of the uncertainty and volatility we’re seeing this year is a result of the invasion of Ukraine, sanctions on Russia, increased energy prices, inflationary pressure, and anticipation of rising interest rates.
As the graph below shows, every calendar year experiences quite substantial volatility. It is normal for stockmarkets.
Source: JP Morgan
Inflation
Inflation accelerated to 8.5% in the 12 months ending March in the U.S, the highest rate in 40 years, and 5.1% in Australia.,
Looking at the U.S where inflation is higher, petrol prices rose 48% over the past 12 months compared to an average +2.8% over the past 40 years, with a downward trend. ‘Core CPI (Consumer Price Index),’ which removes volatile food and energy prices from the equation, ticked up just 0.3% for the month versus the 0.5% expected. However, the overall 8.5% increase is a significant spike.
Inflation is effectively a flat tax on everyone equally, no matter how much money or income you have. It’s a rise in the overall price of goods and services coupled with a decrease in the purchasing power of the underlying currency. Inflation can arise from higher demand for these goods and services – which drives up prices – or it can result from an increase in the amount of money in circulation. The more dollar bills there are in the economy, the less “special” each dollar is (and the more of them it takes to buy your groceries).
Bond Returns
Rising inflation has impacted the performance of global bonds.
If you purchased a bond 12 months ago for $100 which matures in 5 years’ time, you may have required a 2% annual return to take on this risk. This means you receive $2 each year (called a coupon) for holding the bond, and the promise that $100 is returned to you at the end of 5 years.
Given the recent increase in inflation, your required return for holding this same bond may have gone up.
If the market now wanted a 3% annual return for holding the bond, the price of the bond needs to fall below $100 in order for the annual coupon of $2 to equate to a return of 3%.
Consequently, if you wanted to sell the bond now, you would receive less than $100. However, if you hold the bond for the entire 5 years, you will still receive your $100 back.
For this reason, any losses currently experienced in bond funds will be recouped in time. Over the 5 year period, your average return will still be 2%. However, if the value of the bond falls in the early days, it means most of the return will be earned towards the end of the 5 year period. Another way of thinking about this is because the price of the bond has fallen, the expected return of the bond has gone up. So you certainly want to keep holding that bond.
Despite this sound logic, given we have not seen significant inflation for many decades, it can be a shock to investors seeing a loss in their bond fund – even in bond funds holding the lowest risk bonds in the world.
But the mantra of the successful investor remains unchanged - be patient and disciplined and stay the course.
The Return of the Value Premium
For the longest time it felt like tech stocks were the only ones worth owning. The returns of these companies were so strong that no value premium has been evident for much of the past decade.
That dynamic has now completely shifted.
Companies like Facebook, Netflix, PayPal and Shopify have experienced substantial price falls. These four companies alone have lost more than US$1.2 trillion in value over the past year as shown below:
Surprisingly, each of these stocks is now underperforming the S&P 500 since the per-pandemic days at the start of 2020. We purposely underweight portfolios to these types of companies - which we call ‘growth’ stocks - because the evidence shows over the long-term that ‘value’ stocks have higher expected returns. And value stocks are finally shining - so this will be helping client portfolios at present.
The Equity Premium and Staying the Course
At Lorica Partners, every client portfolio is allocated between shares, real estate (listed property), bonds, and cash in a way that aligns with their goals. Our experience tells us that over time, investing in shares is generally a good way to outrun inflation. From 1928 to 2021, the U.S stock market has increased by an average 10% per year. While this wasn’t a straight shot upwards, and there were normal periods of up and down fluctuations, this is still outpacing current inflation rates.
Our investment advice is goal-focused and planning-driven versus market-focused and current-events-driven. In over 30 years of helping individuals and families reach their goals, we’ve found that successful investors continuously act on a plan in lieu of reacting to the market. You’ll find we prefer planning over prognosticating and once your plan is in place and funded, we rarely recommend a change in portfolio so long as your long-term goals haven’t changed.
Lorica Partners client portfolios are based in large part on shares earning a premium over “safe-haven” investments like cash and bonds. The long-term historical annualised return in excess of inflation has been a little over 7% for shares and 3% for bonds. The 4% “premium” provided by shares vs bonds can create a significant impact when compounded over many years.
Imagine you buy $100 of groceries per week. If you invest your money for 20 years in bonds earning 3% over inflation, you’ll be able to buy $180 of groceries per week in today’s dollars in 20 years’ time. An investment in the stockmarket, however, would allow you to buy $390 of groceries per week, giving you twice the purchasing power. By accepting a higher level of uncertainty in the short run, owing shares enables investors to capture a significant increase in purchasing power relative to bonds over longer periods of time.
While market headlines will continue to amplify bold declarations about the future, the four most dangerous words in investing are “this time is different.” Staying the course and remaining invested through uncertainty is the reason why you earn that valuable share market premium over time.
Author: Rick Walker used an article from our friends at Abacus Wealth in the U.S, a member firm of the Global Association of Independent Advisors, as the basis for this article, with his own amendments and additions.