You’ve probably seen the headlines about stock prices crash on a YTD basis for major developed markets…and maybe your US portfolio is even in the red.
Now, investor panic has set in and you wonder what’s going on? Should we stop investing? Should you sell your entire portfolio and exit 100% to cash out?
Newer and younger investors are likely to be more apprehensive as they experience for the first time what it is like to invest in an environment of persistent inflation as well as rising yields.
- People born in the 2000s have not seen average inflation above 3% in the economies of the European Union and North America, which generate a large share of global remittance flows
Over the past 20 years (i.e. since the 1990s), global inflation rates have declined in all regions…North America, European Union, Sub-Saharan Africa, as well as the world as a whole. together.
What is even more remarkable is that since 2009 (over 12 years), the economic powerhouses of North America and the European Union have average inflation rates well below their target range of 2% at 2.5%.
- The average inflation from 2009 to 2020 for North America was 1.54% and the European Union 1.29%.
Therefore, due to low inflation rates, major central banks have kept interest rates low for over a decade to stimulate their respective economies. (i.e. US Fed, ECB, Bank of England, Bank of Canada, BoJ, etc.)
This, in turn, means that government bond yields (yields) in these regions have been very low compared to the historical average, in some cases yields have turned negative.
In other words, with negative bond yields, when the government borrowed from investors, investors had to pay the government. Think about it for a minute, investors lent money to governments but rather than receiving interest, investors had to pay the government (almost like a financial tax to have money to invest)
On top of this absurd scenario, there was over $18 trillion in assets with negative returns and abnormal behavior began to creep into other aspects of money markets whereby some banks began charging customers to hold deposits
In summary, a combination of disappointing GDP growth and low interest rates over the past decade means that bond market returns have not been attractive lately.
Impact on asset allocations and stock markets
With bond market yields relatively unattractive, investors had little choice but to seek other destinations for their funds. So the money previously allocated to the bond markets has now found its way to alternative asset classes.
Over the past decade, growth stocks in US equity markets (especially tech stocks billed as growth stocks), as well as speculative digital assets (cryptocurrencies), have largely benefited from the reallocation of assets away from bond markets.
Unfortunately, the side effect of this change in bond market asset allocations has meant that the valuation of some risky assets has reached an all-time high.
Many investors have argued that this valuation of ultra-high-risk assets is the new normal, especially since for more than 10 years (since 2009) central banks have been trying to induce much higher GDP growth. with very limited success.
However, as is the case with the markets, things will eventually correct themselves. Specifically, the current reality is that the latest round of Covid-19 stimulus packages were substantial (many country plans were in double digits as a proportion of GDP).
Additionally, much of the Covid-19 stimulus support has been funneled directly into the hands/pockets/bank accounts of end consumers (e.g. US, UK and EU have bypassed markets financial institutions and gave money directly to businesses and consumers through various initiatives).
Thus, we are now seeing higher GDP growth as consumer spending has not collapsed as feared and productivity must now keep pace with demand amid labor shortages, labor restrictions travel and shipping logistics nightmare.
- For clarity, in case you were wondering, higher GDP growth driven by consumer spending amid productivity challenges (labour and supply chain) will lead to price changes (aka inflation), meaning central banks need to raise interest rates to control consumer spending while productivity catches up.
- According to the World Bank, GDP growth rate for 2021 to 2023expected to exceed previous years from 2015 to 2019
So what does this mean for Nigerian retail investors?
- The good news is that for USD$ savers, the bond market is coming back to life, and if USD interest rate projections are in line with expectations (up to three interest rate hikes) then we should see activity continue to pick up as investors return to the bond market.
- Additionally, for Nigerian retail investors, dollar mutual funds are likely to see interest rates rise as competition for dollars by Nigerian financial institutions intensifies. You can read more here.
However, unlike equity markets, the reaction to higher interest rates is likely to be mixed depending on the region.
US stock markets
- Market watchers expect that, for US equity markets, rising interest rates will simply mean corrections at the highest valuations.
- Specifically, highly indebted US companies will see their earnings negatively affected by higher debt repayments. There is a good article here on record levels of US corporate debt that currently exceeds $11 trillion. In addition, U.S. companies with high exposure to overseas earnings could likely see their foreign exchange losses increase if the the dollar continues to strengthen against business partners.
We are already seeing US equity markets adjust their valuations and US interest rates haven’t even been raised yet. So more to come as rate hikes begin in March 2022
Emerging Markets Equities
- For emerging markets, the opportunity is that as investors diversify from U.S. growth stocks into real cash flow generating assets to fight inflation, emerging market companies with strong cash flow positive will attract attention. Investors who are bullish on emerging markets include Goldman, Barrons,
- In addition, the collapse of foreign markets may mean that our Nigerian domestic markets can potentially become more attractive as the risk of capital flight decreases (i.e. people will want to keep money at home while watching events unfold abroad)
The overall focus for retail investing hasn’t changed despite all the negative headlines over the past week, as well as the headwinds of persistent inflation and rising interest rates. The objective remains to invest your funds in such a way that, over the long term, you preserve your wealth above the impact of inflation and then grow your wealth.
Yes, we may be at the end of an era where the loose monetary policy stance of central banks generated outsized returns in a handful of US stocks based solely on growth potentials. However, the fundamentals of retail investing remain unchanged, which is to find industry-leading companies that generate strong positive cash flow and are not over-leveraged.
In other words, with rising interest rates and rising inflation, cash flow positive businesses and investments are now coming back as “stock market belle”.