Market analysis : What do inflation and rising rates mean for investors?
The market sits on shifting sands as the world emerges from the pandemic. The last six months have proven to be a volatile period, and various factors continue to affect market performance. The Russian-Ukraine war, lockdowns in China, persistent high inflation, tightening monetary policy and the potential for a recession are a few developments that have garnered the attention of investors; these headlines seem to be dictating the movement of the market. It’s a difficult environment for investors to navigate, but it is also an environment that showcases the value of active portfolio management. In a recent webcast, Portfolio Managers David Wolf, David Tulk and Ilan Kolet discussed current market conditions and how Fidelity’s Global Asset Allocation (GAA) team has been navigating this terrain.
How was the market performance in the first 6 months of 2022?
While the market prospered under the accommodative monetary and fiscal policies brought on by the COVID-19 pandemic, it now faces a change in regime. With U.S. inflation at a 40-year high, the market has begun pricing in potential interest rate hikes from near-zero to 3% by the end of 2022. This has caused the price of stocks to fall globally by around 15%, and for bonds to fall by around 10%, because capital has become more expensive and future cash flows are less valuable.
For many investors, the days of market exuberance are now a distant memory; the major indexes have fallen approximately 10–20% year-to-date, with valuations receding from their pandemic peak. However, David Tulk believes that it is still important to have exposure to risk assets, because “Corporate fundamentals are strong, and there are parts of the market that are objectively cheap.” David Wolf adds that “People have gotten way too fearful about the outlook,” which presents an opportunity for owning more risk assets, because “Fear is a motivation for seeing through the volatility and appreciating the degree to which asset classes can rebound.” These views exemplify the GAA team’s four-pillar process of approaching asset allocation through the lens of macro, valuation, bottom-up and sentiment.
What are the risks for Canada's housing market?
The rise in inflation, and specifically in commodity and energy prices, could serve as a tailwind for the Canadian equity market, given its large energy and natural resource sectors. However, David Wolf explains that Canada’s economy is sensitive to interest rates due to the “buildup of household leverage and the importance that housing has taken in the economy.” Canadian homeowners could face stress if real estate values dip as the Bank of Canada increases interest rates; that would lift mortgage rates, thus reducing demand.
How are emerging markets fairing?
In emerging markets, China seems to present the biggest concern. David Tulk states that “The ongoing zero-COVID policy in China contributes not only to weakness in their own economy but also to the supply chain issues that we see underpinning inflation.”
How has inflation and interest rates influenced the economy?
The Consumer Price Index rose 8.3% in the U.S. and 6.8% in Canada for the month of April, on a year-over-year basis. The rise in inflation is largely driven by a surge in post-pandemic spending. This surge in consumption is the residual effect of the stimulative financial measures put in place during the pandemic, which allowed consumers to withstand a prolonged period of economic inactivity while retaining their savings. As David Tulk puts it, “The inflation problem stems from the actions of policy makers during the pandemic.” Ilan Kolet adds that supply chain disruptions and a tight labour market are also contributing factors, and that “Inflation may remain sticky at higher levels than we’ve enjoyed for the last 20 or 25 years.”
In response to the high levels of inflation, central banks, and notably the U.S. Federal Reserve, are now taking that pandemic stimulus away by unwinding quantitative easing and making aggressive interest rate hikes. David Tulk explains that “As financial conditions tighten, it pushes us further along the economic cycle.”
How does inflation influence the stock market and the bond market?
While many people recognize that inflation erodes buying power, David Wolf addresses another issue that high inflation creates: “When you have inflation that’s more volatile, you tend to have more of a positive correlation between stocks and bonds.” Generally, holding bonds along with equities provides a level of diversification, because the two asset classes are negatively correlated under normal conditions; when the price of equities rise, bond prices fall, and vice versa. However, during periods of high inflation, equities and bonds both underperform due to expectations of rising rates and the erosion of real returns.
Is it time to review the composition of my investment portfolio?
As David Wolf points out, “over the last 30 years, you were fine with a 60/40 portfolio. You owned some stocks, you owned some bonds, they hedged each other – and they both generally went up – and everything was fine. In an environment where inflation is higher and persistent, and where growth is harder to come by, you have to think about diversification differently, because a 60/40 or an index is not going to work as well.”
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Key takeaways
- Inflation is at a 40-year high; stock and bond prices have dropped globally by 15% and 10%, respectively, as capital has become more expensive and the market adjusts to less accommodative post-COVID monetary and fiscal policies.
- Canada’s large energy and natural resource sectors could benefit from rising inflation, but rising interest rates could put stress on homeowners, because real estate value could consequently decline.
- Continued lockdowns in China pose a threat to global supply chains.
- A surge in post-pandemic spending has contributed to the rise in inflation.
- The current market environment is one that may be unfamiliar for retail investors and, in turn, highlights the value of active portfolio management.
- Investors should think differently about diversification and the traditional 60/40 portfolio, because stock and bond prices tend to behave differently in an environment with volatile inflation.
Source: Fidelity Investments Canada, as at May 31, 2022.
Fidelity’s Global Asset Allocation team weighs in, June 2022.
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