Market volatility. What’s unusual this time around and what can you do about it?
By Peter Dine – 19 December 2022
2022 has been one of those years where markets have moved a lot and mostly in a downward direction. There haven’t been many places to hide with shares, property and fixed interest markets all falling. Many share markets have been in “bear market” territory falling more than 20% from their peak in the last 12 months. This is not in itself unusual. In the US, the S&P 500 index has been in a bear market 22 times in the last 94 years.
What makes this downturn unusual is that fixed interest markets have performed poorly at the same time as share markets have been on a downward slide. This is unusual because fixed interest markets typically act as a buffer when share markets are retreating. However, for the 12 months ending 30 September 2022, the NZX50 share market index was down 16.7% and for the same period the NZ composite investment grade bond index was down 9.5%. What is also unusual is the magnitude of declines in fixed interest markets. Prior to 2021, the NZ composite investment grade bond index has only experienced two other occasions of negative calendar year returns in the last 30 years. They were -1.2% in 2013 and -2.8% in 1994. Neither come anywhere close to the magnitude of negative returns from fixed interest experienced recently.
So, what has caused such a large decline in the value of fixed interest investments? In short, the rapid rise in interest rates. Interest rates have been on a downward trend around the world for the best part of 40 years and in 2021 reached historically low and unsustainable levels. It’s not that long ago the world was more worried about deflation than inflation but massive government stimulus during the Covid-19 lockdowns coupled with central banks easing interest rates to near zero levels changed all that. Suddenly people had money to burn, and ultra-low interest rates encouraged consumers to borrow cheap money to spend on goods and services. Supply chains were compromised through the Covid-19 lock downs and the lack of supply saw some eye watering price increases (e.g. shipping costs) which marked the start of price rises generally.
Inflation was coming to life after being benign for decades. At first, central banks thought inflation was transitory, and prices would level off when supply chains recovered. As it turned out, inflation was back and becoming much more entrenched than first thought. While central banks struggled with how to tackle deflation, history taught them how to fight inflation. Hike interest rates and keep hiking them until it has the desired effect.
And that’s where we are today. Interest rates have risen sharply from their lows of 2021 and the risk of a global recession in 2023 is high. Rate hikes are generally negative for existing fixed interest investments because when rates rise, the value of existing fixed interest investments falls and the faster rates rise over a short period of time, the more negative the impact is on values. Rapidly rising interest rates also negatively affects property prices because of the increased cost of borrowing and the relative value between rental yields and interest available from fixed interest investments. Finally, shares are also sensitive to interest rate rises, particularly shares of companies relying on strong future growth in earnings, because investors tend to become more short term in their horizons during times of financial turmoil and discount the value of future earnings. Furthermore, if recession is a consequence of rising interest rates, the contraction in economic activity tends to hurt the profits of companies. In summary, sharply rising interest rates resets the dial for asset prices generally.
What does this mean for investors and their investment strategies? Firstly, at Saturn Advice, we do not advocate knee jerk decisions. Investors who bailed out of the share market at the onset of Covid-19 in early 2020 would have missed the significant rally that followed a few short months later. In most cases, the best approach is to stick to your investment strategy providing it aligns with your financial goals and investment time horizon, and providing you have a suitably diversified portfolio. Sometimes, the hardest decision is to do nothing!
That said, there are things investors can do to position their investments for the environment we are in without fundamentally changing their overall investment strategy. Here are examples of changes Saturn Advice has recommended to its clients in recent months and applied to client portfolios invested through Saturn’s Discretionary Investment Management Service (DIMS).
1: Increase the duration of fixed interest investments
Duration is a measure of the sensitivity of fixed interest investments to changes in interest rates. The higher the duration the greater the sensitivity. Over the last 2 years there has been a material increase in interest rates from historical lows. For example, the NZ 10-year Government Bond rate which reached a low of just 0.5% pa in July 2020 is now trading at a yield exceeding 4% pa. In November 2022, we took the view that while short term interest rates would continue to rise, long term rates were approaching their peak in this market cycle and so we increased the duration of fixed interest investments in client portfolios. This will benefit portfolios when long term interest rates start to fall.
2: Adding alternative sources of investment return
The traditional diversified portfolio invests primarily in fixed interest investments and in share markets, along with a smaller allocation to commercial property and infrastructure investments. The principle is there is a low correlation between the investment returns from fixed interest and shares which smooths out the volatility of portfolio returns. While this is true overtime, it hasn’t been the case over the last 12 months or so. So back in late 2021, we added alternative investments to client portfolios by adding the Man AHL Alpha fund, a trend following investment strategy. In November 2022, we supplemented this allocation with a multi-strategy fund. Our typical allocation to alternative strategies is now around 10% of client portfolios. We believe these alternative strategies provide a genuinely different source of investment returns to complement the more traditional strategies associated with fixed interest and shares.
3: Allocation to Gold
In late 2021, we added an allocation to gold (around 5%) for clients invested in Saturn’s DIMS “plus” investment strategies. Given interest rates were very low and inflation expectations were on the rise, there was an opportunity to invest in gold at virtually no cost. Gold typically provides a good hedge against inflation. In November 2022, we unwound this decision and sold the gold allocation as interest rates had materially increased over this time. Clients benefited from this decision with gains over this period from the allocation to gold of around 7.5%. It wasn’t the price of gold that added the value, though we still thought it was the right decision at the time, but rather the exchange rate gains attributable to a strengthening US dollar.
4: Rebalancing Client Portfolios
This is something we regularly undertake for clients investing in Saturn’s DIMS service. Client portfolios are rebalanced at least one a year and more regularly if we are making portfolio changes, and when clients are adding or withdrawing funds from their portfolio. What this does is trim the allocation to investments that have been outperforming and reallocates funds to investments that have been underperforming. While this may seem counterintuitive, it effectively takes profits from some investments while “buying the dip” with others. It also ensures portfolios remain within the parameters of their investment strategies.
Actively managed funds
Aside from the fund changes Saturn makes or recommends from time to time, the fund managers we appoint to invest on clients’ behalf are chosen because they are specialists in their chosen area of investing and have a strong investment track record. They make active decisions to buy (or sell) company shares, fixed interest investments, listed property, infrastructure, commodities, and currencies based on their analysis of investment opportunities. We track fund manager performance against market indices with a focus on long term (5 years +) returns. Here are a couple of examples of equity funds we invest in.
Bennelong Concentrated Australian Equities Fund
This fund invests in Australian listed companies. While its benchmark is the top 300 listed companies in Australia, the fund typically invests in 20 – 35 companies and currently invests in just 21 companies. Bennelong is focussed on quality growth companies and is comfortable in avoiding entire sectors of the economy if it doesn’t believe there are investment opportunities that meet its criteria. From example, the fund currently has no investment in the Australian energy, IT, REIT, industrial and utilities sectors, but has a strong active position in the discretionary, healthcare and communication sectors. Since the fund’s inception in 2009, it has produced a compound annual return of 13.7% pa, outperforming its benchmark by 3.7% pa.
Scottish Mortgage Investment Trust
This fund invests in public and private companies around the world. The fund’s mission is to identify companies and entrepreneurs building the future, companies that are set to change the world. A long-term investment horizon is observed, and little attention is paid to short term market trends when deciding on the strategy. This patient approach allows market volatility to be exploited for investors’ long-term advantage. An average holding period for investments of five years or more is targeted.
While this fund’s benchmark is an index that includes approximately 3,900 companies across developed and emerging markets, the fund’s equity holdings will typically range between 50 and 100. For the 10 years to October 2022 Scottish Mortgage has achieved a return of 463% (a 16.6% compound annual return pa), more than double the return of the benchmark.
As an aside, the equity funds Saturn recommends don’t typically hedge their foreign currency exposures, that is, they are generally “unhedged” funds. When share markets are falling around the world, the New Zealand dollar typically depreciates against foreign currencies. This means the value of foreign held assets in New Zealand dollar terms is higher. As a result, an unhedged fund tends to perform better than an equivalent fully hedged fund in falling markets. Unhedged funds may not recover quite as quickly when markets bounce back if the New Zealand dollar appreciates in value, but on balance, we prefer this approach as it helps reduce the overall volatility of portfolios.
In summary, what’s unusual about this market downturn is that both fixed interest and share markets have both fallen significantly whereas more typically fixed interest markets provide a buffer when share markets decline. This doesn’t mean investors should make wholesale changes to their investment strategies and it is important for investors to stay the course focussing on their long-term investment strategies.
Without fundamentally changing investment strategies, we have made changes to client portfolios in response to the market conditions we are currently in. Furthermore, the managers we appoint are experts in their areas of investing and are focussed on active investment strategies to provide good long-term returns for investors.
For information about Saturn’s Investment Committee and how it makes investments decisions, watch the video by clicking here. If you are unsure that your investment strategy is right for you, reach out to one of our Saturn Financial Advisers.
The views expressed in this article are the views of the author. The information provided is of a general nature and is not intended to be personalised financial advice. You may seek appropriate financial advice from a Financial Adviser to suit your individual circumstances.