Will higher interest rates push the economy into recession?

by James Parkyn

With so much global economic uncertainty, investors are more sensitive than ever to the comments of central bankers. They parse every word, trying to figure out how high interest rates will go and whether the hikes will push the world’s major economies into recession.

A couple of weeks back, we saw just how sensitive the markets can be to the words of Jerome Powell, Chairman of the U.S. Federal Reserve, the most powerful central bank in the world.

At the Annual Economic Symposium in Jackson Hole, Wyoming, Powell said the Fed’s “overarching focus right now is to bring inflation back down to our goal of 2%.” He went on to say that “restoring price stability would take some time and requires using our tools forcefully to bring demand and supply into better balance.”

The market interpreted the statement that there will be no quick respite from large interest rate increases, raising the odds of a severe recession. The S&P 500 dropped by over 4%.

Central bankers must be careful about every word they utter publicly because they can have that kind of outsized effect on the markets. That’s why I like to listen to what former central bankers have to say because they can speak more freely about the current situation and what’s led to it.

I recently came across an interview with the former Bank of England Governor, Mervyn King, that I found highly insightful and recommend to everyone interested in where interest rates might be headed in the coming months.

King, who was Governor from 2003 to 2013, calls inflation a sign of a sick economy because wages are constantly chasing after rising prices, creating instability and hardship for households and businesses. That’s why it’s so important to bring inflation under control as quickly as possible.

King believes the current bout of the inflation is the result of two errors committed by the major central banks and the economists who advise them.

When the pandemic hit, central banks printed money to stimulate spending and boost demand. At the same time, you had governments injecting massive stimulus into the economy through direct support programs for households and businesses.

However, the pandemic caused a shutdown of economies, constraining production and the supply of goods and services. “You [had] a classic case of too much money chasing too few goods and the result of that is inflation,” says King, speaking in May. He believes government stimulus should have been sufficient to support the economy without the need for central banks to print money.

The second mistake was to rely on economic models that failed to take into account what was actually happening in the economy and instead relied on inflation targets. King noted central bankers can’t make inflation return to a 2% simply by setting a target. Words have to be backed by aggressive interest rate hikes to bring demand back into balance with supply.

As we saw during the inflationary spiral of the 1970s and 1980s, the sooner tough action is taken the better to avoid the need for even more draconian action in the future, he says.

As if they’d listened to King’s advice, that’s exactly the approach that’s been taken in recent months by the Federal Reserve under the leadership of Powell and the Bank of Canada under Governor Tiff Macklem as well as by other central banks. They’ve hiked rates aggressively and clearly signalled more increases are to come until inflation is brought under control.

How high will interest rates go? King says there is no way to know in advance. But he does note the near-zero rates in recent years were historically unusual and unhealthy for the economy because they distorted investment decisions. Will the rate hikes cause a recession? Here again, he won’t make a prediction, except to say it’s likely but not inevitable.

In fact, this former central banker doesn’t have a high opinion of forecasts in general. Who predicted, for example, the pandemic in 2020 or the Russian invasion of Ukraine this year?

“The mistake is to believe you can make accurate forecasts,” he says. “The more important thing to do is not to pretend that we know inflation is going to be 3.2% in a particular year but try to identify the risks. What are the risks on the upside and the downside? What actions can we take to mitigate those risks?”

This is exactly the approach we take in managing investments. We don’t try to predict the future but instead construct portfolios that reap returns from markets while prudently managing risk.

No one knows how high interest rates will go or whether a recession is in the offing. But we can prepare ourselves for different scenarios and then meet challenges as they come with patience and optimism.

For more insights into investing and personal finance, please download our Capital Topics podcast.

You can’t catch a market rebound if you’re not invested

by James Parkyn

What a difference a month can make. At the end of June, I shared some pretty grim market numbers from the first half of 2022.

It was one of the worst ever six-month periods for U.S. stocks and bonds. South of the border, stocks dropped 20%, falling into bear market territory, while bonds were down 8.8%, the biggest decline in four decades. In Canada, stocks were down 9.9% while bonds were off 12.2%.

Then, the markets rebounded powerfully. As of August 18, the U.S. stock market had recovered 13.2% in U.S. dollars while Canadian stocks had gained back 7.4%. The Canadian bond market gained 2.6 % in that same period.

The turnaround may seem surprising but actually, it isn’t unusual, judging by the historical market data presented in a recent webinar from Dimensional Fund Advisors. The webinar highlighted the fact that stock market declines of 20% or more occur fairly regularly and so do bounce backs.

Between 1979 and 2021, intra-year declines in the U.S. stock market averaged 14% from peak to valley. In 10 of those years, the drop was 20% or more. However, when looking at the market history of annual returns, only 8 of the last 46 years were negative.

So, at some point in a year you’re going to have a decent correction if not a bear market, but it doesn’t necessarily mean the year will end in negative territory. That’s why it’s so important to prepare yourself for market declines and not give into fear during those episodes.

The last time we had a first half as bad as this year was in 1970 when the S&P 500 lost 21%. Today’s investors can imagine just how gut-wrenching that must have felt. But in the second half of that year the market rocketed 29% higher and the S&P 500 finished the year at +4%.

Investors who sold their stocks that year because they feared more losses would have ended up missing on a huge rally and gain for the full calendar year.

Indeed, trying to time the market by jumping out to avoid losses and then getting back in when things appear calmer is often a very costly mistake as Dimensional demonstrated in another chart presented during the webinar.

It shows that had you stayed invested in the U.S. market during the 25-year period from 1997 to 2021, $100,000 would grown to slightly more than $1 million, or 10 times your initial investment

Of course, it wasn’t all smooth sailing during those years. There were many times when you could have become spooked by a market decline and decided to go to cash.

If you had and missed out on the best month during this period, your returns would have melted to $865,000. Had you missed the best three months, you would have earned just $731,000.

And as the presenters remind us, you would have also given up a lot of peace of mind. It can be just as stressful to be out of the market when it’s rising as it is to be in it when it’s falling

Now, I’m not predicting that when the end of 2022 rolls around the stock market will show a positive return for the year. We don’t know what’s going to happen between now and then.

However, the reason we earn returns from stocks and bonds is because we are willing to accept a measure of uncertainty and risk in return for the expectation that returns will be positive over time.

And while positive returns don’t come every day, the longer you are in the markets, the more you should expect positive returns. Therefore, the antidote to volatility is to stick to your financial plan and keep focused on the long-term.

As we saw last month, the markets can turn quickly and rise substantially in a short period. To capture those returns, you must be invested.

I encourage you to watch the full Dimensional webinar where not only bear markets but also inflation and recessions are discussed. And be sure to listen to our Capital Topics podcast for more insights into evidence-based investing and personal finance.

Sources: Quotestream and Dimensional Fund Advisors

War in Ukraine: What Should Investors Do?

by James Parkyn

Watching Russia’s horrifying invasion of Ukraine unfold, I was reminded of one of Winston Churchill’s famous quotes:
“The statesman who yields to war fever must realize that once the signal is given, he is no longer the master of policy, but the slave of unforeseeable and uncontrollable events.”

It seems that Vladimir Putin and the Russian military are learning this lesson, but so too unfortunately are the people of Ukraine. Our hearts go out to all those who are suffering as a result of this senseless conflict – the human tragedy must remain uppermost in our thoughts.

Having said that, Churchill’s words also have salience for investors who worry their portfolio may sustain collateral damage from this war.

While the invasion does appear to mark a geopolitical inflection point on a scale not seen since the 9/11 attacks, the consequences for the economy and capital markets remain – in Churchill’s phrase – unforeseeable and uncontrollable.

The invasion has added a huge new element of uncertainty to the global economy that could reverberate for months and even years to come. Right now, markets are trying to digest the potential impact, especially for corporate profits.

Clearly, there will be an impact. Some 400 corporations, including some of the largest names in the world, have announced they will pull out of Russia. Heightened uncertainty and lower profits would normally lead to lower stock prices.

Yet, the reaction in the markets has so far been remarkably muted. While it’s true the U.S. market has entered correction territory, having lost 10.3% this year through March 15, the decline started well before the invasion on February 24. The S&P 500 was already down 11.3% on February 23. So, the U.S. market actually gained 1% during the first three weeks of war.

It’s a similar story in Europe, which being closer to Ukraine, you would expect to be more heavily affected. The FTSE Europe Index is down 9.5% for the year, but just 0.6% since the war started.

The Canadian market has actually been a beneficiary of the Russian invasion. It was up 0.3% for the year, as of March 15, thanks to a 28% rally in energy stocks in response to a surge in global oil prices.

So, the war’s impact on the markets—at least for now—is far less than you would have expected if you had based your judgment solely on dire predictions emanating from the financial media.

While the long build-up to war was probably reflected in lower stock prices before the actual start of the invasion, there were many other factors weighing on the markets. Importantly, investors were faced with much higher inflation and the prospect of higher interest rates.

The media had been focused on that bad news before turning its attention to the war. Meanwhile, it gave short shrift to all the good news on the other side of the balance. This includes strong GDP and job growth, record corporate earnings and the reopening of the economy from pandemic restrictions.

So, what to make of all these developments? Well, there’s the evergreen lesson that the media might be a good source of information and entertainment but is a terrible guide for making investment decisions.

More importantly, we are seeing another proof of just how impossible it is to predict how an event like war will affect the economy or the markets.

In this wonderful article, journalist Robin Power put it this way: “We crave certainty. We want to be authors of our own destiny. And we shrink from the notion that, to a large extent, our lives are governed by luck — both good and bad — and simple random chance.  Everything seems so obvious with the benefit of hindsight. But history happens in real time, and nobody knows — not even the generals or political leaders directly involved — how events will unfold from one day to the next.”

Powell’s advice for how investors should react to the invasion of Ukraine? “The vast majority of investors, and certainly those with a proper financial plan in place, should do precisely nothing.” 

We agree. When we’re asked what we are doing in response to events like the war, we answer: Sticking with the plan. Indeed, risk management is about engineering portfolios to cope with periods of high volatility before they occur.

Volatility comes in many forms and from many sources and that’s the exact reason why you get higher returns for investing in equities. You get paid to take risk, but you must be ready to deal with volatility before it comes. You do it with a portfolio that is broadly diversified across asset classes and geographies. 

Then, it’s a question of staying the course and resisting the urge to trade when the headlines are scary. That’s simple but not easy. It takes discipline and why it’s so important to have a long-term plan to rely on at times like this.

4 Ways to Prepare For the Next Bear Market

by James Parkyn

They say hindsight is 20/20 and that’s never truer than when it comes to the stock market.

When looking back at past corrections and bear markets, it’s natural to see all the factors that led to the downturn. However, the picture is much foggier when you’re trying to figure out when the next one might happen.

In fact, the evidence is that no one can consistently forecast the future direction of the markets – either up or down. Of course, this doesn’t prevent analysts, media pundits and investors from trying to predict the next crash.

As we’ve observed in recent episodes of our Capital Topics podcast, the doomsayers have been particularly vocal of late. They’re saying we are headed for a stock market correction or even a bear market because of the relatively high valuation levels of the markets.

The equities markets have had a strong run. For example, the U.S. market’s total return over the 10 years to January 31 was 17.8%, more than double the long-term expected return. However, experience teaches us that relative valuation metrics tell us very little about the timing of market pullback.

What are corrections and bear markets? A market correction is a drop of 10% to 20% from a recent peak. They usually don’t last very long. After a few weeks or months, the market recovers the losses. Corrections are quite normal; they allow the market to consolidate and take a breather before going higher.

A bear market is more serious. It’s when markets drop more than 20% from their recent highs. They usually last much longer. The triggers for a bear market vary greatly, but they are generally related to poor economic data, a geopolitical crisis or the bursting of a market bubble.

Since 1926, the S&P 500 has experienced 17 bear markets with declines ranging from -21% to -80%, according to this report from Dimensional. The average length of these bear markets was 10 months. The longest bear market was in the early 1930s, lasting 27 months, and the shortest one was the COVID crash two years ago. It lasted just one month.

As humans, we’re not wired for negative market volatility. Behavioural science has demonstrated it triggers our fight or flight instinct, and that’s why investors often make wealth destroying errors during a downturn.

Bear markets are when Investors learn their true tolerance to risk. For the long-term investor, they’re actually a time of great opportunity. But for those who panic, they almost always lead to a permanent loss of capital. That’s why it is crucial to be mentally prepared. A big drop may not happen tomorrow, this month or this year, but you can be sure one will occur sooner or later.

So, how should you prepare yourself for the next drop?

• Have a plan—You won’t be surprised by this piece of advice. You need to have an investment plan that you’ve laid out when the markets were calm and your emotions were in check. The plan must take into consideration your need and willingness to take risk as well as your time horizon. Remember that taking too much risk may lead you to bail out of the markets at the wrong time.

• Have a safe bucket—The best way to reduce risk in your portfolio is to have an allocation to high-quality short duration bonds. This safe bucket should be built with government and other top-quality bonds. Bonds hold their value in a bear market and may even gain, offsetting some of the losses in your equity bucket. If you are a retiree pulling money from your portfolios for living expenses, our advice is to have enough money invested in bonds to cover five or more years of annual withdrawals. This will help you stay the course until equities recover.

• Rebalance regularly—Rebalancing ensures your portfolio reflects your risk profile and capacity for risk. This is especially important during a prolonged bull market when many investors grow comfortable holding a larger percentage of stocks in their portfolios

• Tune out the noise—Finally, keep your emotions in check by tuning out the media noise. Embrace the fact that corrections and bear markets are unavoidable and unpredictable. One day they will end. Remember that if you stay disciplined and stick to your long-term investment plan in a bear market, you will be rewarded when the next bull market comes around.

Don't Fall Victim to Anxiety about Where the Market is Headed

By James Parkyn

When it comes to the stock market, some investors seem to believe in the old adage “what goes up must come down.” They worry that after such an outstanding year in the markets, we must be headed for a fall. This month’s downturn is no doubt feeding those fears.

One way this kind of thinking manifests itself is in a reluctance to invest new money in equities because the market is “too high.” Other investors take it a step further and actually sell stock with the intention of buying back in “after the correction, when prices are more reasonable.”

Before the recent bout of turbulence, the stock market had provided exceptional returns dating back to pandemic crash in February and March 2020. In 2021, the Canadian market was ahead 25.1%, its best year since 2009, while the U.S. market produced a Canadian dollar return of 24.6%.

The 2021 gains put equity valuations at relatively high levels, according to such metrics as the Shiller CAPE 10. However, the same observation was made at the beginning of 2021. Then, the S&P 500 went on to make 70 all-time highs during the year.

As author Larry Swedroe notes in this article, valuation metrics shouldn’t be used to try to time markets. “While higher valuations do forecast lower future expected returns, that doesn’t mean you can use that information to time markets,” Swedroe writes. “And you should not try to do so, as the evidence shows such efforts are likely to fail.”

The advice is equally true for market pullbacks and the days when markets hit an all-time high. These periods are often the trigger for the media and individual investors to start speculating about how portfolios should be readjusted on the fly. That’s when people make wealth-destroying errors.

The danger of succumbing to anxiety by selling equities or holding off on new investments is two-fold. First, you will have to make the thorny decision of when it’s safe to get back into the market. Second, you risk missing out on strong returns while you’re sitting on the sidelines. If you want to know how that feels, just ask anyone who sat out 2021.

When it comes to investing, the antidote for unhealthy emotions is a long-term financial plan with asset allocation targets that reflect your objectives and risk tolerance. As the markets move up or down, you periodically rebalance your portfolio back to your target asset allocations and keep your faith that the process works over time.

Your goal should be to cultivate a long-term investor mindset. Long-term investors ignore the day-to-day noise that comes with volatility and stick to their plan with discipline.