Markets have shown incredible resilience in the face of a number of pressure points. Continued supply chain disruptions from the pandemic, higher costs in food and energy, and tightening monetary policies to name a few.
On the other hand, earnings continue to be strong and optimistic forecasts as demand from economic reopening remain solid. Employment rates are high and consumer/investor sentiments at pandemic lows which have historically been a strong contrarian buy signal.
The Federal Rate hikes are here
In March we saw the first rate hikes since 2018. We now anticipate much more aggressive rate hikes from both the Federal Reserve and Bank of Canada. As inflation pressure persists, the central banks are becoming more concerned about runaway inflation.
An inverted yield curve
The yield curve between 2- 10 years has inverted briefly and the yield curve remains very flat. This traditionally is a signal of recession. It is the bond markets way of expressing their belief the Fed will need to cut interest rates again in the future to stimulate economy.
Market’s inflationary expectation is in backwardation, which means rate of inflation is expected to be lower in the future versus where it is today. This shows markets belief the current high levels of inflation will moderate in the future.
In pricing of financial assets, “real interest rates” are more meaningful because it is a truer reflection of the cost of capital or the price of money. It is measured as nominal interest rates minus rates of inflation. We are still in a low to negative real interest rates environment which bodes well for financial assets.
The Energy Markets
We have experienced a roller coaster ride in the energy markets and have seen the sector almost halved in its valuation in TSX and now rebounding back. The urgency to transition to greener source of energy is no long a subject for debate, however, how we get there without shocking the economy is still a concern.
For us to reach the set 2030-2050 net zero target tabled by many governments and corporations, we will need a coordinated execution from the energy transmission to storage and this will take significant investments.
In the meantime, fossil fuel will still be relied on to keep our economies running, and this will most likely result in higher levels volatility in inflation.
Investing in Fixed Income as rates are rising
Canadian bond index has seen its biggest decline in 20 years. This is as a direct result of Fed/BoC hiking interest rates. It is an important asset class to understand, not only because it offers market intelligence on the state of the economy but also because it is the 40% part of the 60-40 balanced portfolio. Despite the pull back in fixed income, for long term investors, this is a healthy development as bond yields are returning to more “normalcy”.
Here is an excellent chart demonstrating the return relations in fixed income as rates are rising or declining.
A rise in interest rates prompts an immediate decline in the bond portfolio, however, this foretells higher future returns at the higher rates and vice versa.
Bottom line is as long as your investment horizon is longer than the duration of your bond portfolio, poor near term performance will result in higher overall returns over a longer time horizon.
Rita Li works with individuals and business owners and healthcare professionals to provide tailored investment advice, risk management and financial planning. Her team comprises of professionals with in-depth taxation, insurance and legal expertise, together, they deliver a high standard of service to clients. Rita is a Chartered Financial Analyst CFA® and holds her MBA from Richard Ivey School of Business.