What to do after a perfect storm
It has been a stormy 3 months and, no, we are not referring to the weather. By now many people have probably noticed that, regardless of what they are invested in, their investments have had a slightly negative return. It is important to remember that a 3 month period of time is not long enough to judge any investment. Concerns should be restricted to the cause of poor perfomance and long-term implications. With that in mind, let's take a look at what affected the markets this summer and what long term affects are expected.
First, let's look at fixed income investments (FI). Traditionally investors have been told that fixed income investments particularly bonds are low risk investments for short term money or people who don’t want a lot of volatility. What many people don’t realize is that FI are not risk free. The risks associated with bonds are;
Default risk – The company/entity who borrowed your money defaults and does not pay the principal and interest as promised. This was a large part of what drove the crash in 2008. While there have been some big names in the newspapers lately applying for bankruptcy, this is not a wide spread issue at this time and has played a very small, if any, part in the recent drop in bond prices.
Inflation Risk – This is when the inflation rate is higher than the rate you earn on bonds. So while your principal is safe, the value of your money is less. Think if you had $1,000 in your mattress the last 30 years, you would still have your $1,000 but because of inflation, your purchasing power would be much less. This has been a problem with FI for years and has already been fully priced into the market, so it has had virtually no effect on recent bond prices.
Interest Rate Risk – In order to understand this you have to understand what a Bond is. Essentially a bond is a loan. When a company needs to raise capital they issue bonds: They borrow from investors for a set period of time and promise to pay interest in the interim. Bonds are fully transferable so, if you hold a bond and want your money, you just need to find someone else who likes the terms of your bond and you can sell it to them. Because of this, the price of bonds moves inversely to interest rates. This makes sense if you think about it: If you hold a bond paying 5% and current rates for new bonds are 2%, obviously someone would be willing to pay a bit more for yours than for a new one. However, if current rates for new bonds are 10%, you will need to offer a discount to sell your 5% bond. This is what has affected the FI market recently. We have been in a declining interest rate market for approximately 30 years so they have provided a safe haven, with an opportunity for growth, for an entire generation of investors. No wonder people consider them safe. The past quarter saw the Canadian government raise rates for the first time in recent memory, not just once but twice, so it is no wonder FI had a slight decline.
Next up, we will talk about Foreign Market Investments (FE). Anything not invested in Canada is considered foreign market investments. The risks you face in FE vary depending on the type of investment, (Fixed Income, Equity etc.), but they all share currency risk. This is when the currency of the country you are investing in increases or decreases in comparison to the country where you hold the investment. To make this easier to understand we will use an extreme example. Pretend the C$ is worth $0.50 USD and you purchase xyz stock for $10 USD. It will cost you $20 Canadian. Now, if the stock value doesn’t change but the C$ drops to $0.25 USD, when you sell xyz stock you will receive $40 Canadian. You doubled your money even though the stock value never changed. Understanding how tha works, should help you to understand why foreign investments dropped this summer. The C$ increased by approximately 14.5% so naturally any investments, held in foreign investments, will be worth less when converted to C$. Fortunately, those same investments did fairly well in general offsetting some the losses.
Finally, let's discuss Canadian Equities (CE). Shares of any company in Canada is considered a Canadian Equity. The Canadina Equity markets have been down for the last several months because, in Canada, the largest sectors are Resources and Financials. Both of these sectors, as well as manufacturing, can be temporarily slowed by a strong Canadian dollar when it might be cheaper for companies, in other countries, to get their supplies from other markets. Rising interest rates also make it more expensive for these companies to raise capital also temporarily slowing growth.
Now that we know what caused this perfect storm, pushing almost every type of investment lower over the last 3 months, we need to look at strategies going forward to maximize return with an appropriate amount of risk.
Speaking of storms, with the recent disasters around the world, combined with normal expansion, and the lifting of China’s 1 baby rule, the infrastructure sector should remain in favour for sometime to come and could compliment other holdings in your portfolio. As always you should consider dollar cost averaging. This is a sure strategy to reduce volatility in your investments because you will be buying more shares when prices drop and less when prices rise, resulting in a lower average cost per share.
Having finally come to the end of a nearly 30 year drop in interest rates, rates are expected to remain the same or increase for the foreseeable future. As such, interest rate risk will continue to push down returns on FI. If you hold large amounts of FI in your portfolio, it might be time to meet with your advisor and discuss whether or not replacing FI with preferred equity or other dividend bearing investments is appropriate. Canadian Equity Market is expected to rebound and continue to do well so it continues to be a good holding to have in your portfolio.
The Canadian dollar is not expected to stay up for a prolonged period of time. While it is high, it might be a good time to increase FE in your portfolio as you are able to buy it at a discount, and when the dollar drops you will benefit from the performance of the investment as well as the drop in currency.
These are opportunities to take advantage of following the recent drop in the markets but, as with any change in strategy, you should discuss with your advisor to see which, if any, are appropriate for you.