Curmi & Partners

Preparing for tougher times

By David Curmi

Some significant changes have been happening in investment markets this year. As we approach the halfway mark for 2022, we can easily say that this year has so far been a very tough one for investment markets, with local investments also seeing their share of losses.

The main driver behind the negative performance has been the very high and persistent inflation that is being witnessed across economies. Driven by the Ukrainian war and supply chain issues, basic resource prices, in the form of both oil/gas as well as agriculture prices have risen substantially. Inflation markers are now pointing to levels of 8% + across western economies. Furthermore, May numbers surprised on the upside. This dramatic and persistent rise has caught central banks off guard. Rhetoric which at the beginning of the year centred on the “transient” nature of inflation has now forced central bankers to raise rates in both the US and the UK faster and more aggressively than originally was the plan. Europe is not far behind. July is expected to see the first rate increase with the ECB rate forecast to be lifted to zero. Further increases are earmarked for September (50bp) with more likely later this year. Additionally central banks have accelerated the withdrawal of support for bond markets. Quantitative Easing is fast becoming a historic policy tool.

These actions have created chaos in markets. Investment grade bonds have fallen substantially in price, as have sovereign bonds, especially the longer dated ones. Some moves have been devastating and outline the risks of investing in long dated bonds at times when interest rates are on the way up. I have written on a number of occasions, both this year and last, about the need to exit this part of the market, for good reason. Take the 3% MGS 2040 bond. Priced at 126 at the start of the year, this bond has fallen below par, to 98.2 at the last read. This is a 22% drop in the capital value of this instrument, equivalent to over 7 years of interest.

These moves, together with similar moves in equity markets have caused painful reassessments of portfolios as economies now show signs of starting to splutter under the weight of rising prices. Fortunately, consumers remain in relatively good shape having saved substantial income during the last two years, primarily driven by lockdowns. Still, the onset of a recession is growing in possibility and markets are starting to price this in. Further volatility is therefore expected and whilst central bankers are wary of this, their primary concerns remain those of breaking the back of inflation, which is a far more deadly feature than a mild recession.

It's not all doom and gloom though. For the first time in a long time, yields on bonds are starting to look interesting once again. You can actually earn a positive yield on all Malta Government paper now. This will have a knock-on effect on corporate bonds which are currently in the process of being repriced at levels to take into account the above dynamics. For savers this is good news. New bonds being issued on the local market will now be more attractive to savers who for many years were forced into financial repression with a Hobson’s choice facing them in the form of having to take on higher risks to get a return that allowed them to finance their retirement. Whilst this is not music to the ears of issuers who will have to pay higher rates to attract the investors they require, it does shift the balance a little more in favour of investors rather than the borrowers.

At times like this it is also wise to reassess the quality in your portfolio. A number of investors were indeed forced to buy into bond issues only for the coupon. With yields rising, switching to the higher quality issuers becomes a distinct and highly recommended strategy especially as we potentially enter a more uncertain economic period. As with all investments, the higher quality issuers are those that are more likely to emerge stronger from such scenarios and as an investor who relies on bonds to help finance your retirement you not only want to sleep easier at night but also ensure that there is minimal risk of credit loss on your capital.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.