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Feb 2022

The Curse of Interesting Times…

By Mike Leavy, CFA®

The investment markets in 2022 have started with a bang, and not in a good way. In addition to the lingering COVID pandemic, we are experiencing high inflation numbers, Fed proposals to increase interest rates, and geo-political conflict in Eastern Europe. These issues are real and concerning for us, both as global citizens and as investors, and it is natural to wonder what actions we should be taking during these uncertain times.

What can history teach us?

It is always helpful to step back and introduce some historical perspective. Over the past 100 years there have been some other very alarming periods: the 1929 stock market crash, the Great Depression, Pearl Harbor, World War 2, Korean War, Vietnam War, Cuban Missile Crisis, Kennedy assassination(s), the Cold War, 9-11, the financial crisis of 2007-09 and resulting Great Recession, the Russian annexation of Crimea, all the wars in the Middle East, the COVID pandemic… the list goes on. And yet, staying steadily invested in the U.S. stock market since 1926, without any attempt to time markets, would have generated average annual returns of 10.4%. Humans are adaptive, and businesses do manage to adapt, operate, and profit despite the many machinations of the world.

Should I make changes to my investment portfolio?

Our answer is no – there is nothing to do right now, assuming that your investments are positioned properly given your long-term goals and risk tolerance. A well-built strategy is what we rely on in times of stress, in the market or in the world at large. Inaction does not represent sitting on the sidelines, but rather represents placing trust in the process that has helped us weather every previous storm.

This is not to say that there is never any action to take in “interesting times.” For example, after the financial crisis of 2007-09, it became clear to us that certain asset classes, such as real estate stocks and small company stocks, had more risk in panic market environments than we had previously assessed. This caused us to make permanent changes to our asset allocations as markets recovered, lowering our exposure to these asset classes going forward. Additionally, when interest rates dropped to really low levels over the past several years, the low yields of intermediate-term bonds really didn’t justify the risk of those bonds if interest rates were to rise again (when rates rise, bonds lose value – and the longer they have to maturity, the more value they lose). When rates got so low, we shifted out of intermediate-term bonds to short-term bonds, which have lower sensitivity to rising rates.

The point being that there are times to make changes to your target asset allocation, but they are few and far between, and should never be made out of fear or panic. Generally changes should only be made if there is a fundamental change in markets, or if your risk tolerance truly changes (i.e., as you age).

What about inflation and interest rates?

In response to COVID, governments around the globe engaged in unprecedented monetary stimulus in order to make sure economies didn’t collapse, lowering interest rates and using other strategies (such as “quantitative easing” in which they try to push down long-term as well as short-term interest rates). This has resulted in a situation where interest rates are very low, so money is “cheap,” which has the potential to lead to inflation. That said, it’s actually not clear how much inflation risk there really is. Right now, the collective expectation of investors is that inflation over the next ten years will be in the range of 2.4%, as measured by the “10 year break-even inflation rate” between ten year Treasury Inflation Protected Securities (TIPS) and conventional ten-year Treasury securities.

In terms of interest rates, it is our and many others’ view that while interest rates are sure to rise with the upticks in inflation, the Fed will be careful and measured in its management of interest rate hikes and “quantitative tightening.” With the expected rise in rates, we, and many others have moved to short-term bonds to protect against losses in bond holdings as rates rise.

Investment returns going forward

With such low interest rates, investors have had to “search for yield,” which has pushed stock prices up. With both bonds and stocks currently somewhat expensive, it is widely expected that investment returns will likely be lower over the next ten years or so as markets adjust. However, it is unclear how that will play out – will there be a big correction, or will returns just plod along at lower levels for a few years as markets move back to longer-term normalcy? Or, will there be a surge of productivity and economic growth coming out of the pandemic that will actually lead to growth beyond expectations? The overall lack of clarity as to how this will play out means that there is no clear way to game the markets, and it is best to stay the course.

What about the conflict in Eastern Europe?

Arguably the most concerning and uncertain situation we face currently is what we are seeing in Russia / Ukraine. Note that in our portfolios for clients, there is very little direct exposure to investment markets in Russia or Ukraine, or anywhere else in that region – so risk to investments for our clients is not direct, but rather based on the risks posed to the rest of the world. With Russia’s invasion of Ukraine, the key questions for investors are what the effects will be on global trade, energy costs, inflation, etc; and longer term, what repercussions this may have for the broad geo-political outlook. Unfortunately, there is far too much uncertainty in any of this to make a specific course of action clear.  Probably the best way to think about this geo-political situation is to hark back to the historical perspective we referenced earlier in this discussion – 100 years that included many alarming market and geo-political events, but a 10.4% annualized stock market return.

Hang in there…

At the end of the day, the best course of action to support your long-term goals is to keep your long-term, diversified asset allocation in place and systematically rebalance your portfolio to maintain that allocation. This can feel counterintuitive, as we are programmed to take action in the face of stressors and uncertainty – our “fight or flight” impulse – but in investing, it is often best to just sit tight, which is what we recommend at this time.

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