After another year of impressive returns, investors face a more challenging road ahead. Valuations have rarely been higher, and inflation is expected to continue its rise. Even after two years, we still have the virus to contend with.
Though the single most dominant force to consider is the Federal Reserve. The central bank has stated that it will dial back its bond-buying program, planning to wind it down in early spring 2022. Afterward, the Fed hopes to raise interest rates to combat inflation. It expects three rate hikes next year if all goes according to plan.
These are not optimal conditions for those looking for continued gains. Not surprisingly, economists are forecasting muted equity returns. I understand their concerns, though I suspect the Fed will ultimately hold off on raising rates once they realize that the economy is slowing and higher rates would risk pushing the US into a recession. Though, we shall see.
Some have dubbed the current environment as the ‘Everything Bubble,’ and I don’t fault them for doing so. Arguably, stocks, bonds, real estate, crypto, etc., are all in bubble territory. No surprise that asset classes are frothy after a decade (or more) of loose monetary policy.
There are pockets of risk everywhere. What is an investor to do in an environment like this?
Want to buy bonds instead of stocks? If rates rise, bonds are surely expected to fall. Plus, there is a significant disconnect between current inflation levels and interest rates. If interest rates finally align with inflation levels, bondholders will pay the price as bond prices decline.
What about gold? Precious metals have proven to be a terrible inflation hedge (despite what online and radio advertisements may say).
In fact, gold is down -7.5% this year, a year where inflation reached ~6.8%.
Cryptocurrencies? Who knows. It is too new of an asset class to know whether or not it is a store of value or if it is a speculative asset class. More recently, cryptocurrencies have become more highly correlated to the equity markets, impacting their diversification benefits.
If US stocks are pricey, what about international stocks? Sure, though, which international stocks? European, Japanese, and Korean stocks do not look encouraging. China’s economy looks to be slowing, raising the risk of a significant debt situation.
Further, remember that most publicly traded companies are global companies. Most, if not all, operate, distribute, or manufacture overseas. The global economy is truly interconnected. If the US catches a cold, the rest of the world will suffer along with us. The 2008 crisis is an excellent example of this.
Want to sit in cash while all of this blows by? Inflation will eat away at your purchasing power, thus resulting in a real negative return. Plus, when will you get back in? As we all know, this is the single most considerable risk of sitting on the sidelines.
There is never an optimal time to invest. The strategy of staying invested for the long term and deploying dry powder during selloffs is challenging to beat. Crises come and go, yet the markets have always recovered.
The bottom line is that there is no perfect investment. There is no ‘safe’ place to hide. The best bet, especially in this environment, is one of diversification. Spread your bets and stick to your plan.
If there is one thing that we can all count on, it is that the future is unknown and unpredictable. Things will happen that we have not accounted for. But that doesn’t mean that one shouldn’t plan for the future.
Planning for the future doesn’t mean that one has to have all predictions, right or wrong. It instead allows us to be prepared for the contingencies that will eventually surface.
This is very applicable when managing a portfolio. What scenario is likely to occur? What is possible? What is probable? And finally, what is plausible? In today’s setting, there are a lot of possibilities, probabilities, and plausibilities.
For example, there is a high probability of inflation continuing to rise. As such, one would expect that rates will rise too, causing pressure on both stocks and bonds. However, inflation can create an economic slowdown (stagflation) if inflation rises too much. In this scenario, central banks will be very tempted to lower interest rates to ease the economic pain, thus creating a tailwind for both stocks and bonds. (Though, this will only compound the problem, which I talk about here)
These are two completely different outcomes, though both are probable. Nobody knows which, if either, will occur.
It is wise to be at least prepared for both. Thus, the best solution is to hedge both bets and diversify.
Now is the time to have a plan and to stay the course. When we see significant upticks in the market, don’t be too greedy. Likewise, when we see big selloffs, don’t become too fearful. We have a well-tested investment philosophy for situations like this that allows us to be rational during emotional periods. This has served us well in the past, and I suspect that it will continue to serve us well into the future.
If you have any questions or concerns, please feel free to contact us. We are happy to assist.