By David Curmi
In terms of portfolio strategies, 2022 is proving to be one of the toughest on records when it comes to investment performance. Traditionally a portfolio strategy is designed to reflect the risk profile and objectives of the underlying client. Simplistically speaking, a moderate or balanced strategy will typically contain a mixture of asset classes focussed on equities and bonds, probably in the region of 50/50 or 60/40 one way or the other. The thinking here is that traditionally equities and bonds have a negative correlation – in other words when one asset class goes down, you would expect the other to perform positively and vice versa. This would normally give peace of mind that on balance a moderate or balanced strategy will not perform to extremes, either positively or negatively. Hence why it is a moderate strategy.
This year however has been very different. Both equities and bonds have had a torrid year. Depending on which equities or bonds you are invested in you could easily be nursing losses of 15% to 20% so far. Historically this equates to one of the worst performances of such portfolios on record, bar the great depression. What has caused this?
Earlier in the year Central Banks believed that the inflation coming through the system was “transient”. In other words that it would pass through relatively swiftly and that inflation expectations would not become anchored into higher expected inflation. Unfortunately time showed us how wrong the Central Banks were. Coupled this with the war in Ukraine and its impact on food prices and the perfect storm was created. Suddenly central banks changed their stance and gave increasingly gloomy outlook on how interest rates were expected to move, both in Europe and the US. Over the last 10 months we have seen interest rates move from 0 or negative to 3% + in some countries. The speed and magnitude of the moves caught everyone by surprise.
As bonds prices move in the opposite direction to interest rates, we saw significant falls in the prices of bonds, especially long dated government bonds. Drops in prices of 20% at the long end are today common place. The 1.6% Malta Government Stock 2032 issued in February of this year at a price of 103.12 is currently trading at the 85.63 level. That’s a 17% fall in 8 months. Similarly equities have fallen as interest rates moved up. There are two main reasons for this. When valuing an equity using standard equity model valuations, the cost of capital factored in to this model is sourced from the risk free rate, which is ultimately government bonds. As yields in government bonds rise, so this has a downward effect on the valuation of equities. Additionally the outlook for economies has grown increasingly dim as interest rates are pushed up. A recession is now expected in 2023. This means that companies should find growing profits increasingly challenging. If corporate profitability falls then the value of an equity is pulled down alongside this.
Where does one go from here? The outlook for asset classes remains clouded but with such significant falls in both assets classes I am of the belief that markets are at or close to the bottom. With the first signs of inflation having peaked coming through the system we may start to see the pace of interest rate increases slow. This will give markets some breathing room and reduce the risk that economies face a significant recession in 2023. Having cash at the moment is therefore a good thing and starting to deploy this cash cautiously could be an effective investment strategy that helps boost your returns over the medium term. Certainly it is too late to exit the market, in my opinion and changing strategies simply because of one bad year is not recommended either. Perhaps pruning and tweaking your investment portfolio at the margin is more advisable at this point in time. One positive that has come out of the moves in markets this year is that pensioners or savers can now start to earn a positive return on their cash. It has been a long time since we saw this. Financial repression, where savers were forced into riskier investments in search of income has now been confined to history. It’s time to go back into buying quality over simply choosing a high coupon.
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 and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.