David's Weekly Review - June 11-17, 2022
David Crotin, MASc, CIM, QAFP
Working with business owners, executives and professionals to provide tax, investment and financial planning strategies to meet their needs and goals.
In this week’s letter
With the recent turmoil in markets, largely triggered by unexpectedly high inflation, we’ll have a focus today on all things rates and inflation.?Another theme that ties into our discussion is market timing which I cover frequently. So, we'll open with a briefer on that.?We’ll then proceed with the latest in Ukraine from an inflation perspective, covering efforts to reduce energy insecurity and tap existing reserves.?We’ll then look at how good consumers are at predicting inflation.?(They’re pretty good it turns out.)?We’ll then update you on the Canadian Discount Bond Trade and cover the Fed members' own predictions on rates.?The last piece will cover the risks of staying in cash.?Finally, we’ll wrap with the Global Insight Weekly to review the RBC DS Portfolio Advisory Group's perspective on the week’s events.
The Big Picture - Comments Meant for Long-Term Investors
Some of the questions we receive during periods of market turmoil such as we’re experiencing recently include worries about recession, corrections, and bear markets.
In terms of bear markets, there has been one every 5 or 6 years or so since WWII.?During the period since WWII, the US economy has expanded 85% of the time with sporadic recessions for the other 15%.?Since 1980 the S&P 500 has had an annual pull-back of about 14%. So, for most investors, each year there will be a period where their portfolio is underwater.
As we’ve often emphasized, the market cannot be timed with any consistency.?To elaborate, getting out and “waiting to see what happens” results in far worse investment returns than staying invested and riding out the market decline.?History has shown that the only way to realize the full return of equities is to be willing to fully realize the shorter-term declines.
In fact, as this chart below shows, the most dangerous risk of attempting to time the market is missing the up days.?As you can see below, over the last 10 years, if you’d missed the 10 best trading days (out of 2,500), your returns would have been reduced by nearly 50% relative to just staying invested.?As soon as you miss the best 30 days, your returns go to nil.?And missing the best 50 days, that is, the best 2% of trading days, would have resulted in negative returns.?The lesson here is that it pays to stay invested.
Ukraine War
The war grinds on.?Russia’s narrowed ambitions are resulting in some incremental but steady progress, having captured most of Severodonetsk, albeit at a very high cost to both sides.?In parallel to the previous situation in Mariupol, there is a key industrial plant (chemical), within a large tunnel infrastructure, that is now sheltering hundreds of civilians.?The war is at a pivotal point and the Biden administration is now providing an additional billion dollars of aid, some of it for weaponry for coastal defense.?In that respect, Ukraine just destroyed a Russian tug boat near Snake Island using exactly these types of coastal defense systems, raising the cost of the blockade and pushing them back.
Meantime, in a show of support and solidarity, The leaders of Germany, France, Italy, and Romania visited Ukraine and committed to Ukrainian officials that the West would not demand any concessions from Ukraine to appease Russia and will support Ukraine to the end of the war during their visit to Ukraine on June 16.
Below is a recent map of the conflict, courtesy of the Institute for Study of War.
The World Slowly Responds to Energy Inflation and Insecurity Triggered by the War
As the OECD notes, half of the rise in global inflation in 2022 is due to the second-order effects of the Russia-Ukraine war.?In terms of energy inflation and Russia, Saudi Arabia has $2M bbl/day in spare capacity to mitigate higher oil costs.?With Russia now reducing gas flows to Europe, ostensibly because of technical issues (not likely the truth), there is additional pressure on Europe to decide whether this war is simply too expensive.?This thinking might lead to additional pressure on Kyiv to make an unattractive compromise with Putin.?We’ll see how this plays out over the next few weeks.
The economic impact on inflation through food and energy prices remains in place.?In the shorter term, with Biden’s announced visit to Saudi Arabia in July, energy will definitely be part of the discussion. Biden’s popularity is low and historically high prices at the pump are not helping.?Although the administration explicitly stated that the purpose of the visit was not energy, it’s probably a safe bet that it will be central to the discussion.?Any statements about increasing OPEC production, outside of Russia's agreement, could walk energy markets lower.?Biden is also reportedly considering lifting tariffs on some Chinese goods to help the consumer with the overall inflation situation.
In the longer term, recent discussions between Israeli officials and EU President Ursula von der Leyen have resulted in a Memorandum of Understanding between the two countries and Egypt to provide natural gas from Israeli fields via Egyptian facilities. It will likely take years to come to fruition. It’s worth noting that Israeli gas fields are well within range and regularly threatened by Iran’s proxy Hezbollah’s massive missile depots located to the north in Lebanon, so energy security from Israeli sources would still have its risks.
Future Inflation Predictions:?Can the crowd actually get something right?
Usually, the crowd is wrong but in this case, consumers have been able to accurately predict future inflation with a fair amount of accuracy as you can see from the chart below. This is in contrast to the ability of anyone including economists, market strategists, portfolio managers, or traders to guess what the market will do next.
领英推荐
The Canadian Discount Bond Trade Continues for Taxable Investors
For a taxable investor with a 53% marginal tax rate, the BCE BBB+ 2027 bond shown in the graph below will result in the same after tax yield as a 7% 5-year GIC. The chart below demonstrates this. The vertical axis is tax-equivalent returns. The horizontal axis shows the time period of roughly the last two years. The bottom graph, in red, is the 5-year Government of Canada yield. The blue line in the middle is the non-tax-adjusted yield of the BCE bond. The purple line shows the return after adjusting for taxes. The reason there is an advantage on the tax side is that the bond has a low coupon and so is at a discount, so a good part of the return is a capital gain.
Put another way, you’re receiving a “free” AAA to BBB+ yield bump simply by choosing the lowest coupon bond.
If you'd like to discuss this particular kind of trade for your own portfolio, please get in touch.
The Path of Interest Rates:?Better to PLAN than PREDICT
The Fed’s Dot Plot, an estimate by members on future interest rate levels is now showing an average of 3.4% by year-end and 3.8% in 2023.?It’s important to keep in mind that these estimates were far lower only recently and that the path is data-dependent.?As is always the case, recency bias which is human blindsight that results in our assuming that what happens next is most likely to be a continuation of what happened last, combined with the fact that no one knows the future, means that these plots are not guaranteed to predict much of anything with any accuracy.?However, what we can do is plan, rather than predict.?For those that do like to plan rather than predict, and with higher rates on the way, it’s important to be careful about using leverage.
Tip of the week:
The Wealth Minute: Biggest Investing Mistakes: Staying in Cash
Echoing Ray Dalio’s sentiment that “cash is trash”, one of the biggest investing errors one can make is leaving assets meant for retirement in cash for long periods.?The result is the double whammy of losing the benefits of compound interest while simultaneously losing purchasing power from inflation.?And with inflation at very high levels, this viewpoint is even more important.?To learn more, have a look at this video.
By Portfolio Advisory Group
In this week's issue...
That's a wrap for this week. If you'd like to discuss your own portfolio and investment planning or are interested in learning more about how we manage our clients' wealth, please get in touch.
Have a great weekend,
David
416 733-5181
Publisher, Editor-in-Chief at DINE magazine at DINE magazine (Canada)
2 年Well done. This is an interesting and informative article.