Rapidly rising inflation is scary for those who haven’t experienced it — and that’s everyone under the age of around 50. It’s arguably even scarier for those who have. One client’s abiding memory of runaway prices in the 1970s was seeing the advertised price of fuel at their local petrol station change three or four times in a same day!
Thankfully, it’s not that serious yet. But the bad news on prices is mounting. It emerged this week that the Reserve Bank of Australia is edging nearer to raising official interest rates for the first time in more than a decade. Central banks in New Zealand and Canada have already hiked theirs by half a percent. Meanwhile, the Federal Reserve is expected to add one per cent to the United States Cash rate by the end of June; US inflation has hit a 41-year high of 8.5 per cent over the year to March.
It’s not surprising that many investors are anxious. As one financial columnist put it recently, raising rates is like opening a parachute: “Pull the cord too early and the economy drifts. Pull too late and there is a thud… A hard landing means rapid rate rises and share market losses. Or worse, inflation getting away from policymakers and recession.”
People of all ages are affected. Everyday consumers have had their budgets squeezed as the cost of groceries, fuel, travel and pretty much everything has risen. Investors, meanwhile, have seen their bond portfolios fall by 5% to 7% over the past 12 months. And of course, if there is to be a thud, equity markets are likely to fall. It’s not a pretty picture.
But, as always when things look bleak, it pays to keep a sense of perspective. The situation is rarely as grave as the financial headlines suggest. If you’re worried about inflation, and particularly the impact on bonds, here are six things to bear in mind.
Inflation is a key reason why we invest in the first place. Yes, it is higher than it has been for a long time, but inflation has always been a fact of life. Overcoming its corrosive effects is one of the main motivations for investing in growth assets such as equities or property, both of which tend to grow at a faster pace than inflation over the long-term, whilst also delivering dividends or rent along the way.
Bonds have suffered, but other assets have thrived. In any given year, there will always be some asset classes that have performed well, and others that haven’t. True, bonds have had a poor year, with the global bond index returning around -5% for the 12 months ended 31 March. However, the returns delivered by growth assets over the same period have well compensated investors for their losses on bonds: shares (+15% for Australian and +11% for international), REITs (+18%) and infrastructure (+18%).
That’s why it’s so important to diversify and to focus on the performance of the portfolio as a whole, rather than fretting about the one year returns of any particular component part.
Consistently successful market timing is almost impossible. It is very seductive to think that you can determine the right time to get out of and back into a particular asset class. However, the evidence suggests very few investors can do this successfully.
When considering market timing strategies, investors so often forget that there are two decisions involved – getting out, and then getting in. And whilst some investors get one of those calls right occasionally, they very rarely get both calls right.
When all is said and done, most of us have the best chance of succeeding as investors if we resign ourselves to being long term investors – taking the good with the bad, in the knowledge that in the long run, the good times more than compensate for the bad.
Bonds have been a good investment for decades. Sooner or later, the tide was bound to turn. It’s human nature, when a particular asset class goes out of favour, to blame yourself (or your adviser!) for not seeing it coming. The truth is, timing the ups and downs of the markets is fiendishly difficult. It makes much more sense to maintain a well-considered strategic asset allocation and simply ride out inevitable periods of underperformance.
You can use market downturns to your advantage. As we’ve just explained, trying to time the ups and downs of the market is usually a fruitless exercise. But there is an alternative, and far more rational approach that may be used instead. It’s called systematic rebalancing. When a particular asset class has underperformed, contemporary, evidenced based strategists like Minchin Moore, will top up those asset classes using the profits from asset classes which have performed well. It seems counter-intuitive, but systematic rebalances force you to invest rationally — to buy when prices are lower and sell when they’re higher.
One of the counter-intuitive outcomes of the recent sell off in bonds is that it means future return expectations are higher, and higher bond yields also provide a greater buffer in the event of future periods of risk aversion.
Bonds offer varied roles in a diversified portfolio. Considering their recent poor performance, some commentators have questioned the wisdom of holding bonds at all. But, depending on the goals and risk preferences of each investor, bonds may provide several valuable functions in a portfolio.
First and foremost, their purpose is to dampen the portfolio’s volatility, making for a less bumpy ride, and making our portfolio returns more reliable. This is possible because in times of stress and uncertainty, when equities are typically falling, bonds generally rise in value – offsetting the portfolio’s losses in equities. Bonds also offer liquidity; help to preserve capital; and, crucially, help to protect against the impact of inflation, as bond returns include an embedded premium for inflation expectations.
Alternatives to bonds all have their drawbacks. The final point to remember is that investing wholly in growth assets is simply too risky for most investors, the returns just aren’t reliable enough to stack up against our needs. So, most of us need to have a “defensive” allocation in our portfolios to soften the wild ride that equities can deliver. The traditional portfolio approach is to invest most of this defensive allocation into bonds. But is there a valid alternative to bonds? Often commentators tout cash, gold or “absolute return” fund strategies as viable alternatives – but are they really?
Holding money in cash is a surefire way to become worse off, especially in an inflationary environment. Cash interest rates are significantly lower than inflation currently, so the expected return on cash is negative. So whilst cash might offer some protection in the short run, we know it’s a losing strategy in the longer term.
Gold and commodities are often touted as inflation hedges, but they can add risk to your portfolio, and they don’t provide any future expected cashflow (i.e. rent, dividend or interest). When considered objectively, over the long-term, the expected real return (after inflation return) on these assets is around zero.
“Absolute return” fund strategies have become popular in recent decades, however when you dig a little deeper, it seems that most of these strategies are really just “market timing” strategies that rely on the skill (or luck) of their managers. Evidence suggests that the majority of these strategies fail to produce reasonable returns after (typically high) fees. Moreover, survivorship bias means that it is difficult for investors to determine if the ones that do survive and demonstrate compelling track records have been successful due to skill or chance. Ultimately, the glossy brochures and “trust me” nature of these products are hard to justify in evidence.
CONCLUSION
Nobody likes inflation, and it is human nature to want to do something about it. But one of the simple truths about investing is that maintaining your discipline, sticking with your strategy, and systematically rebalancing your portfolio, usually results in better outcomes.
Of course, do what you can to control your expenses and, if you’re still working, to maximise your income. But stick to the plan with your investments. Resist the temptation to tweak your portfolio or change your strategy in response to recent events.
Bonds have served investors very well over the years and will do so again in future. And if we really are heading for that hard landing that many are predicting, you’ll be mightily glad you chose to keep your faith in them.