Stick to your guns when the market wobbles

The new year still feels new but share markets haven’t been partying. Jitters on Wall Street, with ripple effects to other share markets, have raised questions about how this year may pan out.

To be clear, financial markets’ volatility ticked up towards the end of last year on the back of the Omicron mutation coupled with investors digesting the possibility of interest rate hikes by major central banks, particularly the US Federal Reserve (the Fed).

Fed chairman Jerome Powell swept away any doubts over the next move in official US interest rates noting: “I would say that the committee is of a mind to raise the Federal Funds rate at the March meeting.”

‘It’s about time,’ would be a fair summation of many investment professionals’ feelings about Mr Powell’s words.

Data ends arguments about case for interest rate rises

Both the US economy and inflation have been building up a head of steam.

We believe recent data ends any lingering arguments against the case for higher interest rates. The US economy grew by a stunning 5.7% in 2021, the fastest pace since 1984. It was a mighty comeback for the American economic engine as it powered ahead despite the pandemic.

A lot of good news was packed into the 5.7% figure. Unemployment fell to pre-pandemic levels, wages rose, businesses invested strongly, and consumers spent enthusiastically.

However, the bad news is that inflation, as measured by the US Consumer Price Index, was even higher, reaching 7% in December, also the biggest number in 40 years.

Inflation is not a US-only issue with a Pew Research study revealing that inflation in many countries is now higher than before the pandemic.

Most central banks have inflation targets, usually in the 2-3% range, and it’s going to take some effort to pull back inflationary trends.

Forecasters expect inflation to moderate over the course of this year as supply-chain bottlenecks ease and product markets6 become more balanced. But central banks’ policy credibility on the inflation issue relies on decisive action, rather than hope and assumptions over what may or may not happen.

After the terrible inflation of the 1970s — which many argue was made both worse and longer lasting because central banks (and governments) were too slow to act — punishing interest rate regimes from the early 1980s finally began to bring the monster under control.

Once again, central banks’ standing is on the line. What was hard-won can be eroded by inaction and indecision.

Moderate interest rate rises now, to haul back inflation, are preferable to the far steeper rises that will be needed if inflation gets a stranglehold.

Some context on current interest rates

Investors have become so accustomed to the very low interest rates of the post-GFC era that the likelihood of even slightly higher interest rates can create market ripples, as we’re finding out. Just a little bit of unpacking emphasises how unusual current interest rates are.

Presently, the official US interest rate is 0.13% while inflation is 7%. This translates to a real interest rate (interest rates minus inflation rate) of almost -7%.

Think about that; the US has deeply negative real interest rates even though the economy is roaring, and inflation is even louder.

Stephen Roach, a well-known financial markets economist and commentator, notes: “Only twice before in modern history, in early 1975 and again in mid-1980, did the Fed allow the real funds rate to plunge to -5 per cent. Those two instances bookended the Great Inflation, when, over a five-year-plus period, the CPI rose at an 8.6 per cent average annual rate.”

Enough said!

Investors should welcome higher interest rates

Rather than fearing higher interest rates, we think investors should welcome them. Tapping the brakes, so that economies can achieve more sustainable cruising speeds, is a good thing.

Higher interest rates have varying impacts on investments.

They tend to be bad for bond markets but create mixed results for share markets.

Industries and companies with pricing power can pass on higher costs by increasing the prices they charge customers. Those without pricing power have to absorb the higher costs, which dents their profitability.

We’ve been concerned about inflation for some time and that’s why we’ve been moving away from fixed income assets and directing our investors’ and members’ funds towards ‘alternative assets’ with different return patterns to traditional assets.

We believe our alternative assets will also react differently to a rising interest rate cycle than fixed income and shares.

Drawing on full investment toolkit to steer portfolios

The adjustments we made, ahead of recent market jitters, are in-step with principles of diversification, active-management, and risk-control we’ve stuck by since we began managing money for Australians in the mid-1980s.

Diversification means we’re not dependent on good performance from any single asset or type of asset to drive returns. Instead, we’re able to accumulate returns from many assets in many countries and regions.

Diversification ensures a smoother pattern of long-term returns than can be achieved by non-diversified portfolios.

Equally, diversification is valuable when financial markets become volatile, as they have been since the start of this year. Through diversification, stresses in some parts of a portfolio can be offset, to some extent, by resilience in other parts of portfolios.

Active management empowers us to look out for dangers and to avoid them. Through active management and diversification, we’re able to deploy our investors’ and members’ funds towards assets where the changing return opportunity may be higher, and down weight those with lower future return potential.

Very careful about cryptocurrencies

There are no short-cuts, no magic formulas to delivering strong long-term returns. What matters is using the full range of investment management tools at our disposal to optimise returns, and manage risks and pay, what we judge to be, sensible prices to access cash flows.

Incidentally, ‘sensible prices’ and ‘cash flows’ help to explain why we have been sticking by our ‘not yet’, rather than ‘not ever’, position towards cryptocurrencies.

Cryptocurrencies have been all the rage in recent years, but the bursting of the crypto bubble may cause people to reflect more deeply on what cryptocurrencies are and are not.

Assets are something providing cash flows, but cryptocurrencies don’t provide any income. People seem to buy cryptocurrencies simply in the hope of price increases, which is a definition of speculation, not investment.

We are continuing to study cryptocurrencies to see how they may fit in portfolios, and we will only put our investors’ and members’ funds towards assets that can jump a high bar. Until cryptocurrencies can pass a high bar, they will remain off the table.

In the nearly 40 years we’ve been investing, we’ve steered our clients’ portfolios through changing investment cycles, including high as well as low inflation periods, and high and low interest rate regimes.

We’re confident that being faithful to time-tested investment values can navigate our clients’ funds through what may lie ahead.

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