Last year was marked by the return of old problems that most people thought were a thing of the past.
A little history
Since the end of the 1990s, central banks have become accustomed to responding to many problems by lowering interest rates and injecting money into the economy. As inflation showed no signs of life, economists saw it as a period of great moderation. Although the 2007-2008 crisis showed the harmful effects of ultra-low rates, the same recipe was used to contain the damage.
During the pandemic, which hit people and their families hard, governments and Central Banks printed an astronomical amount of money to save the economy. The combination of 0% interest rates and money distributed to everyone has finally brought inflation out of hibernation.
Like gravity
As I wrote in my other memos, interest rates are the equivalent of gravity in the financial markets. Imagine for a moment that we would triple gravity on earth. This would be like tripling your weight instantly. It goes without saying that we would all be much more intimate with the floor of our home.
This is a good comparison with what we experienced in the housing, bond, and stock market. Bonds had their worst year since 1993, when the Canadian index began to be tracked! Stocks had their worst year since 2008.
What shocked people the most was that both stocks and bonds declined. From the 1970s, financial theory has taught us that bonds attenuate the fluctuations experienced in the stock market.
Since central banks have played the role of firefighters by lowering rates, 2022 represented the worst return ever recorded for a balanced portfolio, i.e. -17.94%. Data also supports that all the negative years for a balanced portfolio were years that witnessed an interest rate hike.
And now?
There are certain advantages of higher rates. Among other things, when bonds come due, they are renewed at more favorable terms! Bonds and GICs that paid 2% are being reinvested at 4%!
On the equity side, high interest rates are threatening companies that were living off their debt; such firms must reconsider their business model. A bit like a neighbor who bought an overpriced house at a variable rate, many companies are going through more difficult times today.
No one can predict the economy, financial markets, wars, or even the weather! However, a smart investor always has an umbrella in their car, even when they go play golf on a sunny day. For our part, we continue to focus on profitable businesses that have the ability to take advantage of current market uncertainties.