Will higher interest rates push the economy into recession?

by James Parkyn

With so much global economic uncertainty, investors are more sensitive than ever to the comments of central bankers. They parse every word, trying to figure out how high interest rates will go and whether the hikes will push the world’s major economies into recession.

A couple of weeks back, we saw just how sensitive the markets can be to the words of Jerome Powell, Chairman of the U.S. Federal Reserve, the most powerful central bank in the world.

At the Annual Economic Symposium in Jackson Hole, Wyoming, Powell said the Fed’s “overarching focus right now is to bring inflation back down to our goal of 2%.” He went on to say that “restoring price stability would take some time and requires using our tools forcefully to bring demand and supply into better balance.”

The market interpreted the statement that there will be no quick respite from large interest rate increases, raising the odds of a severe recession. The S&P 500 dropped by over 4%.

Central bankers must be careful about every word they utter publicly because they can have that kind of outsized effect on the markets. That’s why I like to listen to what former central bankers have to say because they can speak more freely about the current situation and what’s led to it.

I recently came across an interview with the former Bank of England Governor, Mervyn King, that I found highly insightful and recommend to everyone interested in where interest rates might be headed in the coming months.

King, who was Governor from 2003 to 2013, calls inflation a sign of a sick economy because wages are constantly chasing after rising prices, creating instability and hardship for households and businesses. That’s why it’s so important to bring inflation under control as quickly as possible.

King believes the current bout of the inflation is the result of two errors committed by the major central banks and the economists who advise them.

When the pandemic hit, central banks printed money to stimulate spending and boost demand. At the same time, you had governments injecting massive stimulus into the economy through direct support programs for households and businesses.

However, the pandemic caused a shutdown of economies, constraining production and the supply of goods and services. “You [had] a classic case of too much money chasing too few goods and the result of that is inflation,” says King, speaking in May. He believes government stimulus should have been sufficient to support the economy without the need for central banks to print money.

The second mistake was to rely on economic models that failed to take into account what was actually happening in the economy and instead relied on inflation targets. King noted central bankers can’t make inflation return to a 2% simply by setting a target. Words have to be backed by aggressive interest rate hikes to bring demand back into balance with supply.

As we saw during the inflationary spiral of the 1970s and 1980s, the sooner tough action is taken the better to avoid the need for even more draconian action in the future, he says.

As if they’d listened to King’s advice, that’s exactly the approach that’s been taken in recent months by the Federal Reserve under the leadership of Powell and the Bank of Canada under Governor Tiff Macklem as well as by other central banks. They’ve hiked rates aggressively and clearly signalled more increases are to come until inflation is brought under control.

How high will interest rates go? King says there is no way to know in advance. But he does note the near-zero rates in recent years were historically unusual and unhealthy for the economy because they distorted investment decisions. Will the rate hikes cause a recession? Here again, he won’t make a prediction, except to say it’s likely but not inevitable.

In fact, this former central banker doesn’t have a high opinion of forecasts in general. Who predicted, for example, the pandemic in 2020 or the Russian invasion of Ukraine this year?

“The mistake is to believe you can make accurate forecasts,” he says. “The more important thing to do is not to pretend that we know inflation is going to be 3.2% in a particular year but try to identify the risks. What are the risks on the upside and the downside? What actions can we take to mitigate those risks?”

This is exactly the approach we take in managing investments. We don’t try to predict the future but instead construct portfolios that reap returns from markets while prudently managing risk.

No one knows how high interest rates will go or whether a recession is in the offing. But we can prepare ourselves for different scenarios and then meet challenges as they come with patience and optimism.

For more insights into investing and personal finance, please download our Capital Topics podcast.

You can’t catch a market rebound if you’re not invested

by James Parkyn

What a difference a month can make. At the end of June, I shared some pretty grim market numbers from the first half of 2022.

It was one of the worst ever six-month periods for U.S. stocks and bonds. South of the border, stocks dropped 20%, falling into bear market territory, while bonds were down 8.8%, the biggest decline in four decades. In Canada, stocks were down 9.9% while bonds were off 12.2%.

Then, the markets rebounded powerfully. As of August 18, the U.S. stock market had recovered 13.2% in U.S. dollars while Canadian stocks had gained back 7.4%. The Canadian bond market gained 2.6 % in that same period.

The turnaround may seem surprising but actually, it isn’t unusual, judging by the historical market data presented in a recent webinar from Dimensional Fund Advisors. The webinar highlighted the fact that stock market declines of 20% or more occur fairly regularly and so do bounce backs.

Between 1979 and 2021, intra-year declines in the U.S. stock market averaged 14% from peak to valley. In 10 of those years, the drop was 20% or more. However, when looking at the market history of annual returns, only 8 of the last 46 years were negative.

So, at some point in a year you’re going to have a decent correction if not a bear market, but it doesn’t necessarily mean the year will end in negative territory. That’s why it’s so important to prepare yourself for market declines and not give into fear during those episodes.

The last time we had a first half as bad as this year was in 1970 when the S&P 500 lost 21%. Today’s investors can imagine just how gut-wrenching that must have felt. But in the second half of that year the market rocketed 29% higher and the S&P 500 finished the year at +4%.

Investors who sold their stocks that year because they feared more losses would have ended up missing on a huge rally and gain for the full calendar year.

Indeed, trying to time the market by jumping out to avoid losses and then getting back in when things appear calmer is often a very costly mistake as Dimensional demonstrated in another chart presented during the webinar.

It shows that had you stayed invested in the U.S. market during the 25-year period from 1997 to 2021, $100,000 would grown to slightly more than $1 million, or 10 times your initial investment

Of course, it wasn’t all smooth sailing during those years. There were many times when you could have become spooked by a market decline and decided to go to cash.

If you had and missed out on the best month during this period, your returns would have melted to $865,000. Had you missed the best three months, you would have earned just $731,000.

And as the presenters remind us, you would have also given up a lot of peace of mind. It can be just as stressful to be out of the market when it’s rising as it is to be in it when it’s falling

Now, I’m not predicting that when the end of 2022 rolls around the stock market will show a positive return for the year. We don’t know what’s going to happen between now and then.

However, the reason we earn returns from stocks and bonds is because we are willing to accept a measure of uncertainty and risk in return for the expectation that returns will be positive over time.

And while positive returns don’t come every day, the longer you are in the markets, the more you should expect positive returns. Therefore, the antidote to volatility is to stick to your financial plan and keep focused on the long-term.

As we saw last month, the markets can turn quickly and rise substantially in a short period. To capture those returns, you must be invested.

I encourage you to watch the full Dimensional webinar where not only bear markets but also inflation and recessions are discussed. And be sure to listen to our Capital Topics podcast for more insights into evidence-based investing and personal finance.

Sources: Quotestream and Dimensional Fund Advisors

Our Best Bear Market Advice from the First Half of 2022

by James Parkyn

The first six months of 2022 were brutal for investors around the world.

Runaway inflation prompted central banks to hike interest rates and that led to worries the economy would be thrown into recession. At the same time, China’s harsh response to COVID outbreaks and the war in Ukraine compounded supply chain disruptions and economic uncertainty.

Markets around the world dropped in response. And it wasn’t just stocks. The bond market, which is supposed to be a safe harbour when the stock market turns stormy, also fell sharply in response to rapidly rising rates. 

Personal finance author Ben Carlson described the first half of 2022 as one of the worst six-month periods ever for stocks and bonds. According to Carlson, returns from a portfolio composed of 60% U.S. stocks and 40% bonds were in the bottom 2% of rolling six-months returns going back to 1926.

And those losses were mild compared to the crash in formerly high-flying speculative assets such as cryptocurrencies, non-fungible tokens and special purpose acquisition companies (SPACs). 

Over the last six months, I’ve written a series of blogs that brings together our best advice for coping with a bear market. Before we recap the highlights of those articles, let’s take a quick look at some key numbers from the fist half.

To June 30, Canadian short-term bonds were down 4.35% and the total bond market, which is the most widely followed benchmark for bonds in Canada, was down by a shocking 12.19%. It’s rare to see such negative numbers in the bond market. The last time a drop of this magnitude happened was in 1994.

Earlier in the year, Canadian stocks outperformed other international markets, thanks to the rocketing price of crude oil and other commodities. However, the Canadian market has been losing ground in recent months and ended the first half down 9.87%.  

One bright spot was large and mid-cap value stocks, which we tilt portfolios towards. In Canada, they had a year-to-date performance of 0.78% versus -20.38% for growth stocks. Small cap stocks have, however, followed the trend downward, they were -13.2%.

In the U.S., we are in bear market territory with the total market is down to June 30 by 21.1% in U.S. dollar terms and 19.4% in Canadian dollars. Here again, large and mid-cap value stocks outperformed growth at -11.01% year to date versus -26.55% for growth stocks.

It’s at times like these that it’s crucial to go back to the fundamental principles of good investing. Here are some of the core concepts I discussed in blogs in recent months that are especially relevant in the midst of a bear market.  

1. Don’t let anxiety drive your investment decisions—The illusion you can time the ups and downs of the market leads many investors to commit wealth-destroying errors. Consider what happens if you sell to avoid more losses. First, you will have to grapple with the notoriously difficult challenge of deciding when it’s safe to get back into the market and second you will risk missing out on strong returns while you’re sitting on the sidelines. Tune out the short-term noise from the media and accept that no one can forecast when the market will go up or down.

• Cultivate a long-term investor mindset—Bear markets are when investors learn their true tolerance for risk. The emotional pressure to decide and act can feel overwhelming at times. But panic almost always leads to a permanent loss of capital. That’s why it’s crucial to be mentally prepared and stick to a plan based on scientific principles. It should include broad diversification across assets and geographies and periodic rebalancing back to target allocations to position yourself to reap future returns. Louis Simpson, who managed the investment portfolio for Berkshire Hathaway’s insurance company GEICO, once said: “We do a lot of thinking and not a lot of acting. A lot of investors do a lot of acting and not a lot of thinking.” 

• Short-term pain in the bond market will lead to long-term gain—Losing money in what supposed to be your portfolio’s safe bucket is unpleasant. However, higher interest rates will lead to better bond returns in the long run. Investors, who have suffered through years of rock bottom bond returns, should want rates to rise, even if it means some capital losses in the short-term.

• Diversification is still your best strategy–It has often seemed in recent years that when trouble strikes, the markets tend to move down together. This raises the question: Does diversification still do the job it’s supposed to do: increase expected returns while reducing risk? The Credit Suisse Global Investment Returns Yearbook is a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900. The 2022 edition includes an examination of diversification across stocks, countries and asset classes. Among the authors conclusions is that “globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.” They also note that international diversification is particularly important in small markets like Canada and highlight studies showing that most investors are woefully under-diversified.

A wise man once said: Expect the unexpected and you won’t be disappointed. It hasn’t been an easy time, but market history shows that the best way to ride it out is to tune out the noise, develop a long-term investor mindset and keep your focus on the fundamentals.

Be sure to check out our Capital Topics website where you will find all our podcasts and blogs to help you become a better investor.

Why aren’t more Canadians maxing out their TFSAs?

by James Parkyn

We can all agree taxes are a burden we have to bear, but one we can try our best to reduce as much as legally possible.

That’s why Tax-Free Savings Accounts are such a good deal and why it’s so hard to understand why more Canadians don’t take full advantage of them.

TFSAs were introduced by the federal government in 2009 to encourage Canadians to save more money for the future.

While you contribute after-tax dollars to your TFSA, any investment income growth earned inside them is not taxed and withdrawals are not taxable. In other words, there are no taxes to pay on the capital gains, interest or dividends in that account.

There is an annual contribution limit each year, which for 2022 is $6,000. If you don’t contribute to your TFSA in a given a year, your unused contribution room accumulates, meaning you could contribute more than the annual limit the next year. If you were a Canadian resident aged 18 or over when TFSAs were launched in 2009 and have never contributed, you would now have $81,500 in contribution room.

Given how attractive TFSAs are as a savings vehicle, it’s remarkable how many Canadians fail to take full advantage of this opportunity, including many high-income Canadians who presumably could afford to make a $6,000 annual contribution.

The latest statistics from the Canadian Revenue Agency show that in the 2019 tax year 15.3 million Canadians held a TFSA and of these people only 9% had maximized their available contribution room. For the wealthiest Canadians earning $250,000 and over, only about 30% of TFSA holders had maximized their contributions.

The average TFSA fair market value per individual was around $23,000 and the unused contribution room was nearly $38,000. For those earning $250,000 a year and over, the average fair market value was roughly $50,000 and the unused TFSA room was close to $22,000.

The lost opportunity cost represented by these numbers is huge. To illustrate this, consider an investor who contributed $81,500 to a TFSA in 2022, plus $6,000 every year thereafter at a 5% rate of return annually over 25 years. This person would end up with over $556,000 that he or she could withdraw and use completely tax free.

The gains could be multiplied if this investor also contributed to their spouse’s TFSA. You can gift money to your spouse so they can contribute to their TFSA without tax or penalty.

It’s important to note that the above illustration assumes that contributions and investment gains stay in the TFSA for the long term. But many people don’t use a TFSA this way. Instead, they use it like a savings account, drawing money out for short-term expenses such as vacations, vehicle purchases or an emergency fund.

We can see this in CRA withdrawal statistics. They show that TFSA holders had made 5.4 withdrawals on average for an average amount of $8,117.

However, as we saw in the example above, for a TFSA to super-charge the power of compounding interest, the money needs time to grow.

Another practice that often has damaging consequences for long-term wealth building in a TFSA is the tendency of some investors to place speculative investments in these accounts.

This is potentially harmful for two reasons. First, as in other registered accounts, capital losses in a TFSA can’t be used to offset gains in unregistered accounts. Second, when you lose money in your TFSA with a speculative bet, you have permanently erased contribution room used to buy that investment.

There are a couple of other things to keep in mind when it comes to TFSAs.

As explained in this article, if you trade too much in your TFSA, the CRA could interpret this activity as an investment business. Under the tax rules, if the trading in your TFSA is considered as carrying on a business, you could be subject to income tax on the income. Separately, you should also be careful about planning what happens to your TFSA when you die.

Tax-free and the government are not usually terms that go together. When they do, you should make sure you’re taking full advantage. Maximizing your TFSA contributions for prudent, long-term growth just makes basic, good financial sense.

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Be sure to listen to our Capital Topics podcast where François Doyon La Rochelle and I discuss important investing and personal finance subjects in terms everyone can understand. You can find it here or wherever you download your podcasts.

Does Diversification Still Make Sense?

By James Parkyn

It’s been a difficult year in the markets and it seems there’s been no safe harbour. With interest rates rising to combat inflation and a tense geo-political situation globally, stock and bond markets around the world have been falling.

As you know, diversification is the fundamental strategy for reducing portfolio risk. Noble Prize-winning economist Harry Markowitz famously described it as “the only free lunch in finance.” Markowitz demonstrated that broadly diversifying within and across assets classes and countries allows investors to increase expected returns while reducing risk.

However, it often seems – especially since the financial crisis of 2008-09 – that when trouble strikes, the markets tend to move down together. So, this raises the question: Does it still make sense to diversify?

To answer this question, we turned to a remarkable resource—the Credit Suisse Global Investment Returns Yearbook. It’s a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900.

The 2022 edition of the yearbook includes an examination by financial historians Elroy Dimson, Paul Marsh and Mike Staunton of the power of diversification across stocks, countries and asset classes. Their study of the historical data led them to several important conclusions.

• Globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.

• The extent to which international diversification can fail investors in a crisis is limited to quite short periods and is relevant only if an investor is forced to sell. “For long-term investors, the enhanced correlations are of less consequence.”

• Over the last 50 years, investing in stocks globally has generated higher reward/risk ratios than investing only domestically in most countries.

• A notable exception has been the United States, where over the last 50 years investors would have been better off investing domestically. This finding reflects the excellent returns and lower volatility of the U.S. stock market during this period. However, the authors also note past performance is no guarantee of future returns. “We are observing these results with hindsight…There is no reason to expect American continued exceptionalism.”

• Investors in smaller markets, especially ones that are highly concentrated in certain sectors, have more to gain from global diversification than U.S. investors because “the U.S. market is already very large, broad and highly diversified.” Canadian investors take note.

• Despite well-known advice to hold a broadly diversified portfolio, the authors highlight academic studies that show most investors are woefully under-diversified. For example, they quote a study (Goetzmann and Kumar 2008) that analyzed more than 60,000 investors at a large U.S. discount brokerage house and found the average holding was just four stocks.

Investors with concentrated portfolios pay for it dearly. A Danish study (Florentsen, Nielsson, Raahauge and Rangvid 2019) analyzed a database for 4.4 million Danish investors and found they could increase their expected return by up to 3% a year by moving from the concentrated portfolio they typically held to an index fund with the same overall risk.

• On asset diversification, the authors write: “Stock-bond correlations have now been mostly negative in major world markets for some 20 years. This negative correlation means that stocks and bonds have served as a hedge for each other, enabling investors to increase stock allocations while still satisfying a portfolio risk budget.”

However, an increase in interest rates is a common variable for both stocks and bonds and this should lead to a positive correlation between them or, in other words, a more limited diversification effect. What’s more, the yearbook notes the correlation between stocks and bonds has been positive for extended periods of time since 1900. So, in the future, the correlation may be positive.

But unless the correlation is perfect, investors will still see the benefits from being diversified in stocks and bonds. And we can’t forget the important fact that bonds are less volatile than stocks.

The yearbook’s authors conclude that “there is a compelling case for global diversification, especially at the current time,” but observe the benefits of global diversification can be oversold if they are presented as a sure-fire route to a superior return-risk trade-off. Diversification should lead to a higher expected level of return for the same risk, but this is not assured.

Therefore, the best we can do is to make well-informed, prudent investment decisions and then patiently stick to our plan, especially when the markets are bleak.