What worked before might not work going forward…it’s time to rethink your portfolio asset mix
Brendan Greenwood, CFP, CIM, B.Comm | August 24, 2022
The global challenges over the past two years (the pandemic, supply chain disruptions, war in Ukraine, drought, food and energy shortages) have driven up inflation to levels not seen in twenty years and interest rates have followed as central banks have moved to reduce inflationary pressures. Rapidly rising interest rates have impacted both stock and bond valuations.
Today bonds are no longer providing the stability and return in investment portfolios they once did. Both stocks and bonds have fallen over 10% in value at the same time. In the past when stocks fell, bond prices would rise or fall much less than stock prices, but this year the global MSCI stock index has lost 15% and the global government bond index has lost 13%. This is the first year bonds, measured by the global government bond index have had a double-digit loss since this data started being tracked in 1986.
Why both Stock and Bond prices are Falling..
Prior to the pandemic, debt levels were high and interest rates were low. Government Central Banks lowered interest rates even further (to near zero) during the pandemic. This increased access to credit and purchasing power for both businesses and individuals. This increased demand at the same time supply chains were being disrupted by all the various global challenges we have had to deal with over the past two years creating the perfect recipe for rising inflation.
Increasing interest rates is the primary tool available to Government Central Banks to bring inflation under control. Rising interest rates force bond yields up and the underlying value of the bond down. This process will eventually reverse itself when interest rates start to fall. However, it is likely interest rates still have further to climb before inflation starts to fall to acceptable levels (current bank of Canada target 2-3%). Rising interest rates and uncertainty adversely impact companies’ earnings potential and what investors are prepared to pay for future earnings so both stocks and bonds have fallen sharply.
Why higher inflation may be here for longer..
Ongoing Geo-political tension combined with global climate change is impacting global supply chains in unanticipated ways that are expected to continue for some time. Covid lockdowns in China have choked economic activity, and even as we see lockdown measures ease in China, the world’s second biggest economy, geo-political tensions are rising. As geo-political tensions rise global trade becomes more difficult.
Europe is seeing a challenging environment stemming from the war in Ukraine, Russia’s dramatic reduction in natural gas supply to Europe and the impact of severe drought. As geo-political tensions continue to rise, regional trading pacts may form between countries that are more aligned in their belief systems further restricting access to product and driving up costs. The chart below shows that global trade as a percentage of GDP peaked in 2008 and has been shrinking ever since.
How to respond..
In order to become more self-reliant countries may direct larger investment towards strategic infrastructure, energy, mining and areas key to economic growth and security such as battery technology and semi-conductors. This creates investment opportunity despite the challenges and uncertainty of the current economic environment. You can still invest for growth to protect purchasing power, but it is increasingly important that you think about overall portfolio stability and explore new investment diversification ideas.
Some exposure to physical commodities (5-10%) that have appreciated in the past in inflationary environments is an option worth considering because changing geo-political realities could limit access to secure long-term supplies. It is possible to gain exposure to commodities in your investment portfolio through three different types of ETFs:
1) Physically backed ETFs
Theses ETFs physically hold raw materials such as precious metals like gold, silver or platinum. Unlike other commodities, such as live-stock, oil or wheat which are costly to preserve and store, precious metals are easily warehoused in secure vaults. This allows an ETF that physically holds gold for example to closely track the spot price of the commodity.
2) Futures based ETFs
Futures based ETFs typically buy and sell futures contracts to gain exposure to the price of a commodity such as oil. These ETFs make money off the spread between futures contracts. Depending on the direction of the commodity price and the contracts the ETF holds the fund will either make or lose money when contracts are rolled over.
These ETFs are generally more volatile, experience significant tracking error and can substantially underperform the spot price of the commodity the fund is seeking to track over the long-term. The higher volatility of these ETFs makes them unsuitable for most investors and are primarily used as a short-term trading tool.
3) Equity based commodity ETFs
These ETFs hold companies that are involved in extracting, producing, storing, shipping or distributing commodities. For example, if you wanted exposure to the price of oil you could buy an ETF that holds a basket of oil refining and drilling companies.
For a more diversified less volatile position you could consider investing in a utilities ETF. A utilities ETF may hold companies that distribute a variety of commodities to consumers such as, electricity, water and natural gas. Investing in equity based commodity ETFs comes with less risk than investing in physically backed ETFs or Futures based ETFs because you aren’t just betting on the future price of a commodity. You are holding companies that have the potential to still earn money even if the commodity price falls.
Assessing bonds held in your portfolio
In the current environment a bond’s term to maturity and quality are important to assess. Shorter terms to maturity will limit the fall in value of the bonds as interest rates rise. Quality is becoming more important because as interest rates rise financially resilient companies with strong cash flow are less likely to default on debt as servicing costs rise. Investment grade bonds rated BBB (triple B) or higher would be considered quality. With yields still relatively low liquid high interest investment savings accounts that pay between 2 and 3% can also be a good place to put some cash in reserve for future opportunities.
The years to come will be different than the past
The world has changed. Many investments will not provide the same opportunities they once did. New opportunities will emerge. Take the time to periodically assess the investments you hold and ask if the mix of assets is still right for the new world that is emerging.
Brendan Greenwood is an Investment Advisor and Financial Planner with Worldsource Securities Inc. focused on personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionals, incorporated individuals, business owners, retirees and their families.
For other articles written by Brendan Greenwood focused on smart wealth planning for individual investors and business owners visit his Blog | GreenwoodWealth
Investing involves risk. Equity markets are volatile and will increase and decrease in response to economic, political, regulatory and other developments. The risks and potential rewards are usually greater for small companies and companies located in emerging markets. Bond markets and fixed-income securities are sensitive to interest rate movements. Inflation, credit and default risks are all associated with fixed income securities. Diversification may not protect against market risk and loss of principal may result. Commissions, trailing commissions, management fees and expenses all may be associated with investing in exchange-traded funds (ETFs). Please read the relevant prospectus before investing. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.
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