17 January 2021
Investing involves the risk that your capital goes down as well as up; you may get back less than you invested. The commentary below is not intended as a recommendation for you to personally buy or sell any of the investments mentioned nor to take any investment action whatsoever.
If we looked at only the overall level of the global stock market in the past few months we could be forgiven for saying that very little has happened. However, a ton has occurred under the surface as some of the more popular investments of recent years have seriously struggled. My sense is that these effects are only beginning to be more widely discussed (there was, for example, an article in the Sunday Times this weekend on the recent underperformance of the hugely popular Scottish Mortgage investment fund).
The crucial question is whether this significant correction for such 'growth' oriented funds has reached its nadir or if we're only in the early stages of reversing what has been perhaps the biggest investing trend since the 2008 financial crisis. To understand where we are going I want to briefly review how we got here.
As we all know, the interest rate we can earn at banks and in other 'safe' investments like government bonds have been virtually zero for years. Indeed, such interest rates have been on a gradual decline since the early 1980s (at least they had been until late 2020). As interest rates - which are really the value of cash - have declined, the opportunity cost of investing in companies has similarly declined. An example: if interest rates are 10% then waiting 5 years for a company to pay you a suitable return on your investments costs roughly 50% in waiting time (10% x 5 years; let's ignore compounding to keep it simple). If interest rates are 0% then there is no (nominal) cost to waiting that 5 years for your return. Therefore, the lower the rate of interest, the longer an investor should be prepared to wait to earn a suitable return.
And so as interest rates fell for decades investing in companies that take a relatively long time to pay a return became an increasingly lucrative and popular strategy. Furthermore, low interest rates help to justify paying a premium for such companies because you can afford to overpay if you are prepared to wait a long time to get your desired return. This is an important point because it has led to investors buying supposedly 'high quality' and/or 'high growth' companies at increasingly high valuations.
As interest rates have begun to rise investment strategies that must wait longer for a healthy return have underperformed quite considerably (for example, Scottish Mortgage has underperformed by 25% since early November though, to be totally clear, Scottish Mortgage and other such funds still have extraordinary returns if we look back further than a year or so).
That's what's happened already; what will happen next?
I am not confident enough to predict that the era of low interest rates is over. For one, society simply cannot handle a dramatic rise in interest rates without enduring huge economic problems and therefore central banks will not willingly allow this to happen. There are reasons to think that inflation will moderate substantially and central banks, after a period of increasing base interest rates, will revert to being more investor friendly. In that scenario, the investment trends of the past decade or so will likely reassert themselves.
However, I am extremely cognisant of the risks that we are in a new regime and properly integrating those risks is, I believe, paramount when managing money right now.
My concern is not so much rising interest rates themselves as, in theory, the equity market should be able to handle it especially if such rises materialise gradually. My worry is that investors throughout the world have done so well by owning investments that outperform when interest rates fall that when the reverse occurs the impact could be disproportionately large. We are seeing indications of this in certain parts of the market now.
And there are indeed reasons to think that interest rates will continue to climb this year including potentially persistently high inflation, rising oil prices following years of underinvestment and central banks selling government bonds in large size.
The answer to the inevitable question of what to do is to seek appropriate balance within one's investment portfolio. This is perhaps easier said than done because while some investments are fairly obviously 'growth' investments many other investments that benefit from lower interest rates aren't so obvious. For example, assets that were 'defensive' in a traditional selloff, when interest rates typically decline, would most likely also fall in value if we experience a selloff accompanied by rising interest rates.
Balance, in my view, involves owning good companies at reasonable valuations as a counterweight to simply paying up for 'extraordinary' companies. It also involves owning investments within the defensive part of portfolios that should not be hurt by interest rates continuing to rise. Investment portfolios with more optimal balance should be significantly more robust in 2022 and for the years to come.
As ever, please get in touch if you would like to discuss any of this in more details and all the very best for 2022,
Scott Tindle, CFA is the Founder & Director of Wealth Management at Tindle Wealth Management
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