With significant negativity in financial markets through the course of 2022 so far, we felt it would be useful to share our current views about what is happening in the world.
The Summary of What’s Happening
The negativity in markets is being caused by inflation being high and central banks around the world increasing interest rates to curb that inflation. It is the speed and magnitude of the increases that has caused so much disruption.
The increased cost of interest increases loan repayments and reduces the amount businesses and households can spend. In turn, if spending falls, companies will have lower revenues and therefore, lower profits. Share prices are typically based on future profits, so if profits are expected to be lower, it makes sense that share prices will fall.
Simply, increasing loan repayments means lower spending. Lower spending means lower company revenue. Lower company revenue means lower company profits. Lower profits mean lower share prices.
Usually, the more complex impact of increasing interest rates for people to get their heads around is that prices of existing bonds will typically fall. This isn’t something that happens often and happens during periods when interest rates increase significantly in a very short time frame. The last time we saw this type of activity was back in 1994.
Simply, increasing interest rates reduces the price of existing bonds. It is very normal.
The Summary of What We’re Thinking
Although uncomfortable for all of us, these are the times when maintaining a solid investment approach matters most. Holding high quality assets that are well managed will result in a positive investment experience – this has always held true. We are seeing no evidence to suggest anything is different this time.
The cause of this negativity is very normal. One would be justified in saying that this is textbook market behaviour. This is nothing like the financial catastrophe of the Global Financial Crisis.
As usual, the media is in a frenzy. There are stories of share markets falling another 20 – 40%, stagflation (which is code for really high inflation for a longer period of time), deep recessions all over the world and, the complex geo-political issues in Europe and China. There is no doubt we could all feel very negative about the current state of the world if all we did is tune in to the media.
However, with striking reliability, very little of what is published actually does anything to help the situation. The purpose is to sell advertising, which is how the media makes its money. So, our best advice is to tune out as much as possible.
Whilst we intend to make this experience a little less uncomfortable or less stressful, it is never nice to see the value of your life savings take a significant hit. That doesn’t mean we are staring down the barrel of a total financial loss situation. Far from it.
A great quote by Warren Buffett is “The stock market is a device for transferring money from the impatient to the patient.” As we have said in the past, in times of negativity, usually the most beneficial action to take is often to hold your current position.
A key part of our job is to help you navigate challenging market conditions. Therefore, if you are worried, please just give us a call.
The More Detailed Explanation
Inflation is driven by two things: demand and supply.
Based on the concerns about the impact of COVID on the global economy, governments and central banks around the world coordinated their effort to stimulate economic activity. This is code for making sure demand doesn’t reduce too much.
Central Banks did this by reducing interest rates, and governments increased their spending in dramatic fashion. That spending was funded by a massive increase in government borrowing. They borrow the money by issuing new government bonds, which are a fancy version of an I.O.U..
A result from this increase in government spending, was that people relaxed, continued borrowing and spending money. People around the world were unable to travel, so a lot of money was then redirected to people’s homes, cars, lifestyle and so on. All this adds up to strong demand.
If there is strong demand, then companies continue to see strong revenue and profits, which drives share prices higher. This is what we saw through mid-2020 through to the end of 2021.
The other side of the inflation equation is supply.
With demand being so strong through 2020 and 2021, one of the issues has been supplying that demand. If anyone has tried to purchase bricks or a bedside table lately, they’ll tell you the wait time is many months and sometimes even more than a year.
There are a range of logical reasons for this. Firstly, with COVID lockdowns and illness, people have simply not been working. Combine that with some fires and floods, which have prevented trains and trucks from delivering goods around the country. Then there is the war in Ukraine, which has significantly reduced supply of wheat (Ukraine was the 4th largest producer of wheat in the world prior to the war). It has also seen Russia restrict supply of gas and oil to western Europe, which restricts production out of some of the world’s largest economies (e.g. Germany has the 4th largest economy in the world, but had one supplier of gas – Russia).
These supply restrictions mean that even though demand has been high, people just haven’t been able to obtain what they wanted to purchase.
When demand is high and supply is low, prices rise. It’s that simple.
Now consider that prior to all this, inflation was low for a long period prior to the past year, including a significantly negative quarter mid 2020 (during the early stages of the COVID-19 pandemic). That was because there were no supply issues and demand wasn’t being fuelled by unprecedented government spending.
This period of low inflation, followed by a period of very high demand and restricted supply has caused a massive spike in inflation. There is no doubt this has exacerbated the experience we are now having. The reason is that central banks have a stated mandate to keep inflation within a target range. Therefore, if inflation spikes, they are required to increase interest rates to bring inflation back within the target range.
It’s worth noting that even our Reserve Bank chair Dr Phillip Lowe was claiming that the RBA would not increase interest rates until 2024. They have been criticised for ‘getting it wrong’, however our view is the error was only that they set an expectation that they have no control over.
As outlined in the simple explanation, when interest rates rise, borrowing costs increase, consumer and business spending reduces, which all equals reduced demand. Company revenues drop along with profits, which then leads to a reduction in share prices.
Not only does an increase in interest rates impact share prices, there is also an impact on other asset values. It is being widely reported that property prices are falling in capital cities. There has also been a significant drop in the value of bonds, which hasn’t happened for nearly 30 years.
All this leads to people seeing the value of their assets fall significantly, which then causes worry, which then easily turns into panic. Combine that with the fact that it has never been easier to sell assets, such as shares, or change the investment allocation within superannuation by logging in.
There hasn’t yet been a time we’ve seen that panic, combined with ease of taking action, leads to a positive outcome. Quite the opposite.
So, as stated in the simple explanation, it’s worth considering that all this market behaviour is completely logical and rational. Whilst it has been a long time since there was a major protracted market fall, that doesn’t make this situation abnormal.
The solution always remains the same. Some key thoughts on this are:
1. Have confidence in the quality of your assets and the way in which your portfolio is being managed. You already took the required action to position yourself this way, which will deliver a solid experience through periods of negativity;
2. Stop looking at the value of your portfolio. Looking doesn’t change anything and it doesn’t increase your control. If anything, it increases worry and anxiety, which reduces your control;
3. If you are struggling, call or email us. Helping you hold your position is a part of our job. Referencing point 1, we have confidence and can impart this as much as you need.
Volatility in markets is a very normal thing and not something to fear. It will pass as it always has, and we will return to positive times before long. Over more than 40 years in business, we have seen this many times and will see it repeated in the future.
To conclude on some positive points, the increase in interest rates through the past few months has seen a major uplift in yields on a range of investments. From term deposits to government bonds, future returns are looking very positive. As we see this market volatility pass, we are very optimistic that we have returned to interest rates being in what we consider is a normal range.
We are also on the positive side of the COVID pandemic. We are seeing people returning to work around the world and therefore, supply is improving and will undoubtedly flow through to reduce inflation.