2022 is proving to be a very poor year for investors. Both Equity and Fixed Income markets are down appreciably year-to-date. As at September 30th, Canadian stocks as measured by the S&P/TSX Composite Index are down 11.1%, US stocks as measured by the S&P 500 Index in $CAD are down 17.2% and Canadian bonds as measured by the FTSE Canada Universe Bond Index are down 11.8%. As a result, these returns are adversely impacting the merits to a diversified, balanced fund approach. Year to date, only cash is posting a positive return.
Markets have sold off because of the recent uptick in inflation and on the central bankers’ efforts to restore price stability via interest rate hikes. The recent surge in inflation is a global phenomenon driven by the world coming out of the recent pandemic which created both pent-up demand coupled with a disruption in the ability accommodate supply (i.e. the supply chain issues). The ongoing war in the Ukraine has also played a role as global supply chains are adjusting and Europe in particular looks to reset its energy suppliers. Inflation numbers surged to 40-year highs with consumers noting the sudden increases in the prices for energy (gasoline in particular) as well as food and housing too. Central Banks have responded with sharply higher interest rates which will ultimately lead to reduced demand for goods and services. They have stated that they will aggressively work to prevent inflation from becoming entrenched in the economy – even noting that higher interest rates will reduce economic growth and employment. Of particular concern to investors, the resulting “demand destruction” could lead to an economic recession – perhaps globally. So the current interest rate shocks have and are continuing to rattle both the equity and the fixed income markets. While rates have increased appreciably thus far, more rate hikes are coming over the balance of 2022 and into 2023. So, at this point, we are only part-way through the process.
Investors were optimistic during 2021 on expectations for economies to re-open post COVID, pent-up demand from consumers, cash savings that had been accumulated during the COVID shut-down and general expectations of economic growth along with strong earnings and cash flow. Investors expected interest rates would rise as they had been taken to extreme lows during the pandemic. Most would have expected interest rates to return to pre-pandemic levels in a slow and moderate way (i.e. in 0.25% or 25 Basis point increments). Moderate hikes are preferable as they do not shock the financial markets. We expect there will be more interest rate hikes looking out to the end of 2022 and possibly into 2023. Inflation and central banks will remain the primary focus for investors.
It is important to remember that investing invariably entails a trade-off between risk and reward. Historically, the Equity markets tend to drift higher on the back of economic expansion and on companies’ ability to generate earnings and cash flow growth for their shareholders. With respect to Fixed Income markets, we have been in a multi-decade declining interest rate environment which took interest rates down to zero during the pandemic and even to negative levels in some countries. From this point, interest rates really had no where to go but up so there wasn’t a great surprise for investors that rates would move higher. What has been a surprise over the past 6 months has been both the size of the recent rate hikes and the speed at which we have reached materially higher levels.
It is important to note that financial assets do not always appreciate. There are regular down drafts – the market corrections (i.e. a decline of more than 10%) and the Bear market declines (i.e. a decline of more than 20%). Corrections occur quite often with respect to asset classes, sectors and even individual securities. Bear Markets however are far less frequent and are often closely tied to serious disruptions such as an economic downturn – with the expected length and severity of the downturn driving the length and severity of the bear market decline.
It is important to remember that we have had material market declines before and that the markets eventually recover and move on to new highs thereafter. In March of 2020, governments basically engineered an economic recession as economies were shut down due to COVID. The S&P 500 Index dropped by 36% in about a month. Similarly, other markets also sold off as we feared what the pandemic might do. The markets recovered quickly primarily with the development of a vaccine and most investors enjoyed strong returns for calendar 2021. Looking back to 2008/2009, recall that the Financial Crisis led to a 56% decline for the S&P 500 Index from its previous highs. Here too, investors returns were materially negative but later recovered as markets and sentiment improved.
Periodic weak markets are part of the investment landscape. It is important that investors understand the trade-off between risk and reward and have an appreciation for their degree of risk aversion. Weak markets are a serious test of the investors’ tolerance of downside and provide an excellent read of whether their portfolios are acceptable from a risk/reward perspective or are perhaps too aggressive for their tolerance of risk. If the investor is unable to tolerate occasional periods of weak returns, then their portfolio is not a good fit for them. While most investors are more than happy to accept the upside of strong returns and the higher volatility that produces these returns, downside volatility is the better test of portfolio fit.
Just as hope is never a sound investment strategy, investors are advised not to overreact or panic to finding themselves in a weak market environment. Unless you need to access your capital now, there is no need to crystallize your “paper loss” into a real loss. If you have a long investment horizon before you need to draw upon your portfolio, you can afford to wait out the current weakness and you will have the time required for your portfolio to recover. Consider this analogy….
Would you elect to sell your house today because prices have declined over the past 6 months and are expected to decline further looking out to 2023? Probably not – unless you absolutely had to sell now.
If you do not have the luxury of a long investment horizon before you need to access your assets, then you would be advised to have a less-aggressive, more conservative portfolio. It is common practice for investors to move toward less risky portfolios as their time horizon shortens. If the investor has need for funds over the near-term (e.g. 18 months or less) we would recommend that they have near-term capital requirements in a risk-free, cash holding.
As mentioned above, the extent to which you are uncomfortable with a decline in the market value of your portfolio is a good way to determine if your portfolio is appropriate for you and reflects your tolerance for risk.
What is OAL Doing Given the Weak Markets of 2022?
We have previously moved to a Defensive posture and we remain positioned Defensively. Our goal currently is to preserve capital in face of weak markets rather than taking on risk to seek returns.
We have reduced Equity exposures to the lower end of our permitted tolerances, we have increased Cash to upper permitted levels and we have reduced Duration risk in the Fixed Income portion of the portfolios (i.e. moved to less volatile Short-term Fixed Income from longer duration Universe Fixed Income).
We are and remain hunkered down, taking shelter from adverse markets (akin to bracing for a hurricane).
We will reposition when we believe the risk/reward outlook is favourable. We do not expect that we or anyone else can precisely time when markets have bottomed – this will only be obvious after the fact. And so, we intend to move back to risky asset exposures in a phased approach.
Looking ahead, the current weakness will mean that future returns are likely to be above-average. As many well-regarded and successful investors (here think of legendary investors such as Warren Buffet, Sir John Templeton, etc.) will tell you, weak markets are the best time to add to exposures – be greedy when others are fearful!
We intend to capture these future above-average returns – not by blindly taking on risk and hoping for the best, but rather by taking a measured, prudent and disciplined approach to increasing our risk exposures going forward. Of course, we do not plan to go “all-in” at the moment markets have bottomed. We expect a phased approach will be better in terms of adding exposures carefully and being rewarded going forward.
So yes, 2022 is and is likely to remain a very poor year for investors. Looking ahead however, a strong case can be made that future returns will be attractive and we intend to capture such for our clients. With the benefit of a longer-term perspective, it is reasonable to expect markets will recover and move on to new highs. This is not an overly simplistic or optimistic perspective – setbacks and crises are part of the investment landscape and time and time again, the markets later recover from such.