boat for web.jpg

Market and
economic update

JUNE 2022

mobile with text.png
WHAT HAS BEEN HAPPENING IN INVESTMENT MARKETS?

Towards the middle of June, the US share market (as represented by the S&P500 index) officially entered a bear market – it is now down more than 20% from its peak in January. The Australian market (as represented by the ASX200 index) is not faring much better, being nearly 15% off its recent peak in April.

This significant downturn is being driven predominantly by fears about spiralling inflation, and thus the spectre of steep increases in interest rates.

The Russia / Ukraine conflict plays a major role in this as well, because of the potentially far-ranging economic consequences that could result from Russia being effectively removed from the global economy by the western world (as a result of trade restrictions and other punitive measures imposed by western countries), as well as the fact that Russia and Ukraine are major exporters of energy and commodities such as wheat and a range of other essential products (Ukraine being the world’s largest exporter of fertilizer, for instance). We have already seen a steep increase in global energy prices, as w  ell as the Australian Reserve Bank (among other central banks) have started increasing cash rates in an attempt to rein in rampant inflation, and this will add to cost-of-living pressures, which are already becoming challenging for many families.

Much of the inflationary pressure is the result of supply-side disruptions that have their origin in the numerous pandemic lock-downs and restrictions around the globe over the course of the last two years; however, consumers also played their part in driving up demand for goods and services (and investment assets, including shares and property) due to the ample supply of “cheap money”, i.e. the extremely low interest rates and other measures that central banks and governments used to support businesses and consumers during the worst of the pandemic lock-downs.

THE BIG QUESTION IS: How quickly will interest rates increase, and how high would rates have to go before inflation is brought under control?

As long as the answer to this question remains the subject of wide-ranging speculation, investors will continue to be fearful about corporate valuations (and thus about share prices), which were already at or near historic highs at the end of 2021.

Most companies with strong growth potential (technology companies such as Amazon, Tesla, Apple and Microsoft being prime examples) are valued heavily on their future earnings potential. Accordingly, when it seems likely that interest rates will rise significantly in the near- to medium term (which will affect consumer spending, corporate earnings and the cost of capital), the discount rate used to calculate the present value of future cash flows has to be adjusted upwards, resulting in a lower valuation. This is why we have seen technology companies, in particular, suffering very significant declines in their share prices since January 2022. And since these stocks tend to constitute the bulk of the “growth” component (e.g. shares, property) of most diversified investment portfolios, it means that the “growth” component of most portfolios would have declined in value since the start of this year.

No doubt, rising interest rates (or even just the fear of rising interest rates) will affect the Australian property market as well, and we are already seeing values declining in Sydney and in Melbourne. For now at least, no “growth” asset is immune to the effects of high inflation and rising rates.

WHAT ABOUT THE “DEFENSIVE” COMPONENT OF YOUR PORTFOLIO?

The “defensive” component of a typical diversified portfolio consists predominantly of bonds (both government as well as corporate bonds). Bonds are essentially loans to the government and to large corporations, and they entitle the bondholder to regular interest income that is fixed at a particular rate, with capital being returned at the end of the term (note that one can also invest in variable rate bonds). Bonds are tradable, in similar vein to shares.

If market (“floating”) interest rates move up or down, or are expected to be moving soon, it can affect the capital value of a fixed-rate bond, since the instrument will continue to pay interest at its particular fixed rate. Thus, bonds do not only generate interest income; they can also experience capital growth or capital declines, with gains or losses being realised if the bond holder was to sell their bond to another investor.

Since interest rates generally do not fluctuate significantly, bonds tend to be far less volatile than shares, which is why they are included in most diversified portfolios – they usually “smooth out” portfolio returns. This is also because their values tend to move inversely to that of shares: when shares perform strongly, bonds tend to deliver muted returns; conversely, when share markets decline, bonds tend to perform relatively well.

Unfortunately, we are currently in a somewhat unusual situation: coming out of a practically zero-interest environment, and with inflation threatening to get out of hand following a period of very strong equity market performance, there is a possibility that interest rates will increase significantly and rapidly, and that they may remain high for a considerable period. As a result, bonds have taken a hammering over the course of the last twelve months, with the decline in capital values overwhelming the income generated by these assets during the period in question.     

Right now, we are thus seeing negative share market returns coincide with negative bond returns. In other words:
at the moment, bonds are not providing the kind of “ballast” that we would generally expect them to provide within a diversified portfolio. This is not something that most investors would have experienced before. Going back thirty years, Australian bonds have only delivered negative returns in two calendar years, with both of these occurring during periods when equity markets produced very strong returns (January to December 2021 being the last example). The same applies to international bonds.

In our opinion, it is likely that the current devaluation / decline in bonds has run its course (or is close to it), and we thus expect that bond returns will revert to positive figures in the near- to medium term.

THE OUTLOOK GOING FORWARD

In light of the above, it is important to view the year-to-date performance of your portfolio in context – it has been a very challenging period indeed, and generating positive returns under these conditions would have been very difficult, if not impossible, for most investors.

Market sentiment remains broadly negative in the short term, and this is likely to remain the case until the outlook for inflation improves – once that happens, we will have a better idea of how interest rates may move going forward. There are indeed market commentators who believe that the rampant inflation we’re seeing at the moment is transitory, i.e. that it is predominantly due to supply-side disruptions that occurred during the height of the pandemic, and that it will normalise fairly soon, as the world recovers from these structural disruptions.

Nonetheless, with the current level of uncertainty persisting, it is entirely possible that share prices could come under further pressure, and, for the same reason, bonds may continue to produce poor returns as well.

This could change quickly though, and one should keep in mind that markets are forward-looking; in other words, we should be mindful of the fact that investors are already “pricing in” negative future circumstances, and that this is reflected in current asset prices (e.g. share prices). If investors get an indication that the inflation / interest rate outcomes are likely to be less severe than they feared, share prices as well as bond prices could correct upwards rapidly. Of course, the opposite could also occur, but there is no doubt that the cycle will reverse at some point, and when it happens, the recovery could be fast – that is why it is generally not a good idea to attempt to “time the market” by moving in and out of the market based on one’s perception of “tops” and “bottoms”, especially if one has a well-diversified portfolio.

As you may be aware, there are also fears that the global economy could tip into recession, in other words, an extended period of declining economic activity / output and depressed asset values. While this remains a strong possibility, it is worth pointing out that spiralling inflation is not a feature of a recession – in other words, a recession situation should spell the end of the current fears about rapidly-increasing interest rates.

This also means that, while share prices may struggle during a recession, bonds are likely to rise in value, thus providing the kind of “ballast” that we generally expect them to provide within a diversified portfolio. As implied above, the current situation where shares and bonds are producing negative returns simultaneously is somewhat anomalous, and likely just part and parcel of a “normalisation process” after a highly unusual period, i.e. the pandemic and the measures applied by governments and central banks to support their economies.

DON’T SUCCUMB TO SHORT-TERM-ITIS: THE IMPORTANCE OF STAYING THE COURSE

While you would likely have seen a decline in both the “growth” as well as the “defensive” components of your portfolio over the last six months, this is the result of very unusual circumstances, and you should thus not lose faith in the fundamental longer-term diversification benefits built into your portfolio. Six months is a very short period in investment terms, and one should guard against reading too much into short-term performance figures, regardless of whether they are positive or negative.

When all is said and done, the underlying assets that you are invested in are the companies that produce the goods and services that power our economies – longer term, these economies have produced increasing value and have rewarded its investors handsomely. This is unlikely to change anytime soon (and a good business does not become a bad business simply because its share price has fallen) but the price that we have to pay for this growth potential is that we occasionally have to endure periods of significant uncertainty and discomfort.

Periods like the one we are experiencing at the moment is a real test of investors’ mettle – when one is bombarded with bad news on a daily basis, the temptation to capitulate (to “cash out” and thus to realise losses) can be very strong. But history shows that markets are very resilient in the long run – they always bounce back eventually. And the recovery can be much faster than most investors expect: for example, the S&P500 index (US stock market) has declined by 10% to 20% more than twenty-five times during the last seventy-five years, and on average it took only around four months to recover the losses suffered during these downturns.

For most investors in well-diversified long-term portfolios, the greatest risk factor is probably not market volatility by itself, but rather their emotional response to it – either because they get ahead of themselves (“greedy”) when things go well, or because they become excessively fearful when things take a turn for the worse.

Managing these emotions is easier said than done, so, as always, we would encourage you to engage with us if you should have any questions or concerns about your portfolio – now, more than ever, it is important to be mindful of your emotions and to continue taking a disciplined and reasoned approach to your investment decisions. This approach has served countless investors well and, no doubt, it will do the same for you.

Daniel Rossouw
Joel Evans

DISCLAIMER: Any advice provided in this document is of a general nature and does not take into account personal circumstances. Any decision to invest in products mentioned in this document should only be made after reviewing the relevant Product Disclosure Statements. Past performance is not a reliable indicator of future performance. Evans Rossouw & Young Wealth Management does not accept liability for personal financial advice unless such advice is in the form of a written Statement of Advice. Please consult with your adviser before taking any actions that may have an impact on your financial affairs.

The Trustee for JDD Wealth Unit Trust trading as Evans Rossouw & Young Wealth Management

t 02 9922 6155  |  clientservice@erywealth.com
Level 26  100 Mount Street  North Sydney  NSW 2060  |  PO Box 1890  North Sydney  NSW 2059
Principals: Joel Evans CFP® (BCom CA)  |  Daniel Rossouw CFP® (BProc, Adv.Dip.FS)
ABN 13 506 902 489

Evaro logo1.png