Investment Focus | Issue 15 | When Will the Pain End?

It’s been a hard year and not the one many hoped for coming out of a two-year pandemic! Unfortunately, the solutions to our economic problems in 2020 and 2021 are now the catalysts for the terrible year we have had so far in 2022. We are in a bear market right now and bear markets are painful. They last, on average, about 330 days. They fall, on average, about 32% from their peaks. They return to their starting point, on average, in about 1.7 years. Those are averages; bear markets can be better or worse. What caused this bear market? The Fight Against Inflation.

Why is inflation running so high?

There are two basic reasons why inflation has been so high: supply and demand. On the demand side, consumers have been on a spending spree after spending two years been cooped up at home bingeing Netflix. Adding to the demand, governments added support to households’ buying power with pandemic stimulus funds and lowering interest rates leading to access to ultra-cheap debt.

The same is true of markets where central banks undertook massive quantitative easing, which basically means they bought government bonds and other securities on the open market to inject money into the economy. The supply side has been an issue due to COVID-19 restrictions (especially in China) leading to manufacturing shutdowns and port delays.

The conflict in Ukraine has also led to inflation, primarily contributing to the demand side of oil (as wars require a lot of oil!) and a reduction in the supply of oil, gas, and grain as Russia cut off pipelines and shipping ports.

All of these factors have led to the highest inflation rates we’ve had in 39 years (8.1% in July). The Bank of Canada’s target inflation rate is 2%, so we are well above the benchmark. It’s important to get back to this target or consistently high inflation could lead to something called hyperinflation. This occurs when expectations that prices will keep rising fuels more inflation, reducing the value of every dollar in your pocket.

How has the government been tackling inflation?

The main tool central banks use across the world is interest rate policy. By raising interest rates, borrowing costs rise and consumers have less disposable income. The higher the rates, the less spending room we have. If raised enough, it curbs inflation as demand lowers and then companies have to increase prices more slowly or lower them to attract business. However, if rates are raised too much, it can cause a recession by lowering demand too much. This is the delicate balancing act that the central bankers find themselves in right now.

How do rising interest rates affect bonds (fixed income) and equities (stocks)?

Bonds have an inverse relationship with interest rates. When rates go up, bond prices go down which lowers the market value of your bond portfolio. This intuitively makes sense as bonds pay coupon (interest) payments, so if rates are rising, new bonds will pay a higher coupon rate, making older bonds less valuable (their market value drops). Although rising rates negatively affect the value of your bond portfolio in the short term, the increase in interest rates does has a positive effect, as the maturing bonds are reinvested in new bonds with higher yields. Also, it’s important to remember that although bond values can drop in the short term, if held until maturity, they pay out the face value of the bond. Most bond fund managers are holding on to their bonds right now, rather than selling them at a loss. As they mature, the bonds are paid back in full, and the manager can then invest in higher yielding bonds.

Stock indexes also historically go down when interest rates go up. Higher rates make future company earnings less valuable. Why is that? They are less attractive compared to bonds that are paying more competitive yields today. Because stocks are priced based on future earnings, the stock price goes down as well.

Where do we go from here?

The consensus expectation is that the Federal Reserve will likely raise rates two more times in 2022 and one more time in 2023 for a total of 150 basis points (or 1.5% higher). For Canada, the consensus is there will be one more rate increase this year. The fixed income market has priced these hikes in. When it comes to fixed income, we have likely seen the worst. It’s a fool’s errand predicting a bottom, but if not there, we are close. Most fixed income managers have a short portfolio duration of 2-3 years. Duration is a measure of the length of maturity of the bonds. What this means is that as your bonds start to mature, you will be made whole on the value of the bonds and new bonds will be paying higher yields. This is not the time to get out of bonds (as evidenced in the next chart).

For equities, the challenge now is whether we end up going into a recession in 2023 or not. There’s no consensus here, with some analysts saying we hit the bottom of the market in June and most recently bounced off that bottom again last week. Others are saying we have another 10% loss potentially before we hit the bottom if we head into a recession. What we do know is that history shows that equities usually have a higher return 12 months after the first rate hike.

Two Crucial Lessons for Weathering the Storm

1. A recession is not a reason to sell
Are we headed into a recession? A century of economic cycles teaches us we may well be in one before economists make that call.

But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. As the below shows, returns have often been positive while in a recession (recessions are shaded in green).

Whether accompanied by recessions or not, market downturns can be unsettling. But over the past century, US stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline.

A year after the S&P 500 crossed into bear market territory (a 20% fall from the market’s previous peak), it rebounded by about 20% on average. And after five years, the S&P 500 averaged returns over 70%. We believe that staying invested puts you in the best position to capture the recovery. If you take risk out of your portfolio, it should be a strategic, not tactical, choice. We believe the only good reason to sell out of a stock portfolio now—so long as it’s diversified and low-cost—is because you learned something about your risk tolerance, or your investment goals have changed.

2. Time the market at your peril
When stocks have declined, it might be tempting to sell to stem further losses. You might think, “I’ll sit out until things get a bit better.” But by the time markets are less volatile, you’ll have often missed part of the recovery. Yes, it stings to watch your portfolio shrink, but imagine how you’ll feel when it’s stuck while the market rebounds.

Big return days are hard to predict, and you really don’t want to miss them. If you invested $1,000 in the S&P 500 continuously from the beginning of 1990 through the end of 2020, you would have $20,451. If you missed the single best day, you’d only have $18,329—and only $12,917 if you missed the best five days.

History shows the stock market tends to rebound quickly. The same can’t be said for individual stocks or even entire sectors. So, while investing means taking on some risk for expected reward, investors should mitigate risks where they can. Diversification is a top risk mitigation tool, along with investing in fixed income and having a financial plan.

The worst thing you can do is assume bad times will continue indefinitely—just like it’s dangerous to assume good times will last forever. Booms plant the seeds of busts like the one we’re in now… but busts also plant the seeds of booms.

Please feel free to reach out to us if you would like to discuss your investment plan or any worries that you might have, and we would be happy to talk with you.