David's Weekly - October 7, 2022

Plan – Don’t Predict

We’re experiencing another highly volatile week in the markets with pundits both looking for bottoms and others declaring the violent 5% rally earlier this week as a bear market bounce. There are considerable differences of opinion on where inflation might go next and what the terminal Fed overnight rate will be. In terms of the Fed’s tools to control inflation, namely monetary policy, the secretary general of the WTO, Ms. Okonjo-Iweala, pointed out that “there could very well be supply-side constraints that are not responsive to interest rates, with some danger that central banks could overshoot". Again, we are in part talking about de-globalization here.

But if demand is the main antagonist to inflation, Fed tightening should help, simultaneously repricing risk assets, home prices and inputs. However, with the USD strengthening enormously as safe haven, we will likely see pressure on other economies, particularly emerging markets, which have borrowed in USD.

As an interesting tidbit, I’m including some anecdotal evidence that regular folks believe the Fed will go too far. In a poll we posted on Linkedin this week, admittedly not statistically significant, we see that most voters believe that the Fed will in fact go too far, echoing some sentiment on the “street”. What we wonder here is, are people “talking their own books”? That is, sometimes we support the hypothesis that suits our own goals the best. Here are the results, to date:

This Week's Letter

• International News: OPEC+ and Ukraine
• Time in the Market vs Timing the Market – the longer the holding period, the safer the return prospects
• Bond Market Pain – Is it time to sell? Me thinks not.
• Looking again at inflation expectations: Is this recency bias? Maybe not after 50 years.
• Global Insight Weekly

Webinar Announcement

Next Wednesday October 12, we’ll be reprising our webinar on the New Approach to Wealth Management.

Here’s the RSVP link. When you arrive at the Webex page, please follow the Register link.

International News: OPEC+ and Ukraine

This week the OPEC+ group decided to reduce oil output, ostensibly for maintaining “price stability”. With the challenges of energy insecurity, the Biden administration’s likely goal of mitigating high energy costs has been snubbed, to some extent as a result of the chilly relationship between the two erstwhile geopolitical, defense and energy partners.

In Ukraine, now much more firmly in the headlines after a period of disinterest, we’ve all heard about the rapid moves to recapture Ukrainian territory that was only just declared part of Russia by the Kremlin. There’s a great deal of conflict in the information space within the Russian sphere that is causing a split amongst various parties that are otherwise all nationalist and pro-war. 

Our favourite analysts are excited about Ukraine recapturing all of their territory with continued international support (primarily from the US), to do so. However, a Ukrainian victory is not a foregone conclusion and we should expect at least some successes from the Russian side in future months. This isn’t to express an opinion or prediction, but more of a caution that recency bias might be tainting some of the analysis. 

Russia has in the past turned things around. We only have to look back to World War II. What was different in that case was that the Russian successes at pushing back the Nazi war machine were essentially a defensive war, fought on Russian territory and then expanding outward, while the Ukrainian war is also a defensive war fought on their territory. In a way, the Ukrainians are the Russians, and the Russians, the Nazis.

Time in the Market vs Timing the Market – the longer the holding period, the safer the return prospects

We’ve talked about this before, and we’ll talk about it again. The most important part of an investing plan is the time period over which you are invested. When we speak to clients about what they are trying to accomplish, timeline is essential. That is, any funds that are earmarked for expenditures over the near term – any time up to 3 or even 5 years, should be invested in the lower end of the risk scale. That might include securities such as:

• GICs
• short-duration, investment grade bonds
• government bonds
• Banker’s Acceptance Notes

However, it is key to understand that over the long term, investing in the higher risk segment of the market, and in particular, equities, has a very high probability of positive returns after only 3 years of investment, and nearly 100% with a little more patience.

Looking at the chart below, we can see that, for the TSX, and similarly for the S&P500 (not displayed here), longer-term investing in broad, large-capitalization western markets is a winning strategy.

Historical odds of earnings positive total returns over various rolling holding periods

Source: RBC Dominion Securities: data going back to 1977.

Bond Market Pain – Is it time to sell? Me thinks not.

We’ve said this many times during volatile periods and will probably do so again:

“When they’re cryin’ you should be buying. When they’re yellin’ you should be sellin’”.

-Dennis Gartman

Bonds yields have been on a secular downtrend for decades in the western world. Why is this? We’re not economists here but with globalization and ageing populations, inflation has been, to date, manageable and held in the 2-3% range. Countries that are growing rapidly tend to have high birth rates, high inflation and high growth. Western countries, typically have had less of all those elements. Lower rates typically lead to higher borrowing. When major market bubbles were burst in the last 20 years – i.e. dotcom bubble, great financial crisis, and the COVID-induced sell off, central banks provided massive amounts of liquidity, ultra-low short-term rates and quantitative easing which results in lower longer term – i.e. mortgage - rates. That has put downward pressure on interest payments from bonds and supported inflated financial markets and home prices.

Traditionally bonds have provided the stabilization part of portfolios. When equity markets sell off, investors naturally run for safe havens such as government bonds which typically rally higher during stressful periods. Not so this year. As we can see below in the Bloomberg global aggregate total return index which measures the return both from coupons as well as any capital gains that result from buying bonds at a discount and holding them to maturity, returns in the bond market, as a result of inflation, have been spectacularly abysmal, down 17.4%. The next worst period was 1999. So, this is historic stuff.

Source: Bloomberg

With many bond holders accounts down significantly, would now be a good time to jump ship? We’re not in the business of making predictions in this letter, but it’s the author’s own humble opinion, that now is the best time to own bonds in over a decade given the high rates of return achievable. Even though portfolios are down significantly, those current holdings could potentially perform very well going forward.

What could go wrong? More inflation and higher rates. As always, it’s important to purchase bonds whose maturity date occurs BEFORE your investment time horizon is reached. (For readers that are interested in learning more about the latter topic, here’s a video from a year ago where we explain further: The Silver Lining in Today’s Bond Market.)

Again, not predicting anything, but sometimes it’s darkest before the dawn. Moreover, extremes in price movement, such as we’ve seen, often revert to the mean, that is, they moderate.

If you have more questions than answers about your own bond portfolio and how it fits into your plan, please get in touch.

Looking again at inflation expectations: Is this recency bias? Maybe not after 50 years.

Plan for inflation when you think about the future. Build it into your portfolio and your financial plan. That way, you are prepared for challenges if they arise. We aren’t necessarily in agreement with the predictions of lower inflation in the chart below, but it is interesting to see that surveys indicate a belief that inflation next year and in 5-10 years will approach the longer term averages. And these views aren’t likely because of what happened most recently. The recency bias, if it applies, is related to the fact that inflation has been low for decades. The combined charts show the U Michigan expected change in prices during the next year, (top) and over the next 5-10 years (bottom), respectively. The top chart shows near-term inflation expectations falling toward the average while the bottom shows longer-term inflation is expected to be below the average. Of course, this is only a prediction, but people continue to believe that inflation will normalize. And, that is good because if higher inflation expectations become entrenched, it becomes a much tougher nut to crack.

Latest University of Michigan Long-Term Inflation Expectations, Monthly Since 1990

Source: Bloomberg, Fundstrat.

Wrap

We’ll continue to monitor the markets but this is a process that will take some time to resolve. As optimists, we believe that things will get sorted out. With inflation, war, continued supply-chain problems and considerably tightening financial conditions, we can expect continued volatility and uncertainty. Now is the time to review your plans! Please get in touch to make sure everything in your plan is on track.

Global Insight Weekly

This week’s letter focuses on the importance of defensiveness and the likelihood of continued market volatility as the markets adjust to our current reality of high inflation, higher rates and global instability.

By Portfolio Advisory Group

In this week's issue...

Receding liquidity exposes risks - Long dry spells and retreating water levels are exposing many finds from forgotten archaeological sites to discarded cars. Similarly, the receding tide of monetary liquidity, as western central banks hike interest rates, is exposing long glossed over financial vulnerabilities and systemic risks. In this environment, we expect financial markets’ volatility to continue. We would stay defensive and up the quality of portfolio holdings.

Regional developments: Canadian economy narrowly avoids contraction; U.S. equities move higher ahead of pivotal week; UK long bond yields rise as market eyes end of Bank of England’s bond purchases; Hong Kong’s economic recovery faces a bumpy road.

Please take some time to review the Global Insight Weekly.

Feel free to contact me with any questions and/or to discuss investment ideas.

I appreciate the opportunity to serve you and look forward to continuing to help you accomplish your long-term financial goals.

Have a great weekend,

David