Investment Update - July 2022
With financial markets falling and most investors seeing portfolio values heavily down this year, we thought we would write a quick update on what is happening and some thoughts on a key topic.
The big financial story this year has of course been the return of high levels of inflation not seen in the last 30 years. This has in turn lead to interest rate rises in many countries, with the expectation of more to come over the next 6 months.
The sharp resurgence of inflation is down to a myriad of issues; the re-opening of economies and supply chain issues post pandemic (enhanced here by Brexit-related trading frictions). Energy and food prices had already started increasing before the Russian war in Ukraine, which has driven them rapidly further.
In the UK we have also been impacted by the value of the Pound falling, which increases the price of imports. Pound Sterling has fallen over 10% against the US Dollar over the last year – particularly relevant, as that’s what oil is priced in.
How bad are things?
We’ll stay away from crypto asset meltdown and make no comment, other than they are not an investment (no income, no economic rationale for a return).
As for stock markets, you may have seen recently that the US market[1] hit a 20% loss from its previous peak, denoting a market “correction”. A US investor would have seen similar losses on international shares.
For a UK investor however, things are probably not as bad as the headlines (and general pervading doom and gloom) will have led you to believe. The main reason being the pound falling – increasing the value of overseas assets in Sterling terms e.g. $1,000 cash was worth about £730 a year ago and is now worth c. £825.
To a UK investor in GBP terms, the US stock market has only fallen c. 11%, rather than 20%, due to that currency movement (about the same as global stock markets[2] as whole) and the UK stock market[3] has fallen just 4.6%, aided by a large weighting to energy firms.
These losses, whilst painful for many are fairly modest by historical standards (e.g. compared to 2020 Covid falls, the Great Financial Crash and the Dot-com bubble this century alone) and should be entirely expected when investing in equities.
The difference over the past 6 months / year has been that the value of bonds has fallen too.
What’s going on with bonds?
Over the last 30 years we’ve had a secular trend of interest rates falling across developed markets. This has seen the returns on bonds largely only go up over this time.
As interest rates fall, fixed bond yields become relatively attractive and their prices rise. The reverse has happened over the past few months; interest rates have risen, fixed yields on bonds have become less attractive and prices have fallen.
So, an obvious question is, if interest rates are going to keep rising (which looks very likely) aren’t bond prices going to keep falling?
Not quite; markets don’t wait for events to happen before prices adjust, they change in anticipation of them. Bond (and equity) prices reflect the market’s aggregate expectations of interest rate rises moving forwards – they are certainly not assuming there will be no further rises.
What will drive a change in the price of bonds is a change in those expectations of future interest rate rises (and other variables, including inflation). If interest rate rises are faster and greater than currently expected, then bond prices will fall further. And if interest rate rises are slower and less severe than expected, bond prices will rise.
The arithmetic of bond returns
A key difference between equities and bonds is how returns are generated. With a bond (assuming no default by the borrower), all future payments are known. This is not the case with equities.
If you hold a (conventional) bond to maturity, you will get the prescribed interest (coupon) payments and the face value back at maturity. If you have no intention of selling the bond, the market price in the meantime makes no difference.
For example, imagine a bond bought for £100 that will pay £2 income per year and the £100 capital back in 10 years. No matter what the market prices that bond at in the meantime, you will still get those payments. It is the expected return relative to that new price that changes.
If the market suddenly prices that bond at £120 the day after you buy it, the expected return on that new £120 price would be zero - the total payments from the bond only equal £120. Conversely if the market suddenly priced that bond at £80 the following day, the expected return on that price would be about 4.5% p.a.
In that scenario, the value (what you could sell it for) of your bond has fallen by £20/20% on the first day. However, the cash payments due haven’t changed. You will still receive those. They will just equate to 4.5% p.a. of the current price, rather than the 2% p.a. on the original purchase cost.
That is essentially what has happened over the past few months. The price of bonds has fallen, but the expected return moving forwards has increased. If you continued to hold the same bonds to maturity (again assuming no default), losses would be recovered.
Therefore, the shorter the duration of the bonds you own, the quicker losses will be recovered (ignoring any trades conducted by a fund manager that detract value). For owners of short-dated bonds, interest rate rises will be a positive over the medium to longer term, due to the benefits of higher interest yields.
What can be done?
At the risk of sounding like a broken record our advice to all our clients is to stay the course with their plans and not to panic. Nothing has fundamentally changed in the way the world and capital markets work. They’ve seen high inflation and rising interest rates before. They’ve seen war before. Long-term, markets have always rewarded investors for supplying their capital.
There is a reason why people accept the risk of investing in capital markets – returns. The amount of risk you accept (in order to obtain a commensurate rate of return) should be driven by your personal circumstances. Unless these have changed, think hard before making changes, particular in response to short-term market movements. As we’ve written in blogs before, panicked decisions in volatile markets can be a very quick way of destroying wealth.
Returns stated are Total Returns 31/12/2021 – 30/06/2022, including income reinvested. Data sourced from Financial Express Analytics.
[1] Measured by the S&P 500 Index
[2] Measured by the MSCI All Country World Index
[3] Measured by the FTSE All Share Index
Disclaimer:
This document should not be considered a recommendation to purchase or sell any particular investment. Care has been taken to ensure the accuracy of content, but no responsibility is accepted for any errors or omissions. We do not predict or guarantee the future performance of any individual security, investment, portfolio or asset class.
Image Source: Unsplash
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