This year so far has proved a tough year for investors. Since December, the Australian All Ordinaries index is down around 11%, the US500 is down around 18%, the NASDAQ is down a whopping 33% and this is the same story across most stock indices around the world.
If your portfolio is more defensive in nature, you would have likely still felt some level of pain. Long duration bonds have been sold off as interest rates rise and cash…. well your initial investment will still be there but with inflation currently running at 5.1% in Australia, the purchasing power of that money is being eroded!
So yes, it’s been a tough start to the year. But let’s not forget that this is investing, and investing is not a one-way street – it has its ups, and it downs. But what is the outlook from here? Are we over the worst of it?
Well, I would love to tell you that I knew for certain the answer to that question, but I don’t – no one does! However, I do want to point out some of the headwinds facing investors moving forward and follow that up with my movements in the current market.
Let’s list out some of the risks we are facing. I do warn you, it’s a big list.
- High inflation – Australia’s current rate of inflation is 5.1%, the highest it’s been since June 2001 when the GST was introduced.
- Increasing interest rates – The Reserve Bank of Australia (RBA) surprised us this month with a higher-than-expected increase of 0.5% to the official cash rate bringing it up to 0.85%. Many are predicting it will be above 3% by the end of the year which would put variable home loans somewhere in the range of 5% – 6%.
- Quantitative tightening – This is a big one in the US where quantitative easing could switch into quantitative tightening. The Federal Reserve will stop buying bonds and may even sell some bonds back into the market or leave them to mature.
- Lower real wages – wages aren’t rising as fast as inflation which means people’s purchasing power is going backwards.
- Lower consumer confidence – consumer confidence here in Australia fell 5.6% in May. This means people are less likely to spend and invest, slowing down the economy.
- Risk of recession – The US has already had one period of negative GDP and its not unlikely that they will have another, leading to a recession. If inflation remains high and economic growth slows then we are potentially facing a period of stagflation.
All of these risks are interrelated, but the overarching theme is that we have just gone through a period of massive stimulus in financial markets with low interest rates and quantitative easing and, put simply, the party is coming to an end.
Central Banks have decided that inflation is a problem, and they are going to fight it. The biggest risk for financial markets is how aggressively will they fight.
If interest rates continue to rise modestly and inflation comes down a little bit, and they eventually meet somewhere in the middle, leaving us with a neutral rate, then the landing should be reasonably soft.
Under this scenario, there should be a good foundation for businesses and consumer confidence to rebuild, which should see that translate into higher asset prices.
On the contrary, if inflation remains high (or even worse, gets higher) then we can expect to see more aggressive moves by central banks which can be highly recessionary and can cause a lot more pain in asset prices.
For me, the biggest determinant that you need to consider in this market (and always) is your investment time horizon. If you have a very short time frame on your investments, i.e. you will need that money at some point in the next 5 years, then your portfolio should incorporate defensive assets to accommodate that need.
The good news is, with rising interest rates, you can start to generate a better return on defensive assets like cash and bonds.
On the other hand, if you have a long investment timeframe (over 7 years) then it’s probably best to just accept the current market movements – it’s part of investing!
It definitely hurts in the short-term to see your past profits disappear but remember, your job as an investor is to collect a pool of high quality, diversified assets which will eventually replace your earned income. If the current market is giving you an opportunity to gather more of those assets at a lower price, and you have the capacity to do so, then now may be a good opportunity to dollar-cost average in.
This is not the kind of market where you want to make brave moves. I never condone going all in or all out. This is a time to reflect on the intentions behind your portfolio, check all of your assets to make sure they are high quality and diversified, and continue down a path which suits your specific needs.