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Investing in Volatile Markets

  • Inflation in Australia is currently above 5 percent and higher in many other countries
  • Reserve Bank of Australia inflation target is 2 to 3 percent pa
  • RBA cash rate currently 1.35 percent; may go to 3 percent by early 2023
  • Unemployment at 3.5 percent should insulate Australia from economic recession for now
  • A financial plan that positions a portfolio which is resilient against many different outcomes is appropriate in today’s market.
Investing in volatile markets

Current Market Conditions

The 2022 financial year has challenged investor confidence as the impact of Coronavirus brought on lockdowns and supply chain disruptions, along with rising inflation and higher interest rates.

The war on Ukraine has exacerbated these problems by pushing up input costs, including oil, gas, iron ore, coal, and wheat. This has fed into higher household energy and fuel costs, as well as higher food prices. Inflation around the world is now at levels not seen in more than 40 years.

The Australian share market fell by around 10 percent in the 2022 financial year while house prices around Australia are now falling. This downward trend in house prices is likely to continue as interest rates rise in the months ahead.

Inflation in Australia is currently sitting above 5 percent, and at higher levels in many other countries. The stated target inflation rate by the Reserve Bank of Australia (RBA) is the within the range of 2 to 3 percent per annum.

This implies that the RBA will continue to increase the official cash rate until inflation falls to within this target range.

Looking Ahead

On 5 July the RBA Board stated that they will continue to raise interest rates until Australia’s inflation rate is within the 2-3 percent target range. The RBA is confident that this target will be achieved in 2023.

To achieve this inflation target, interest rates will continue to rise over the next 6 months or so. This means that the official interest rate as set by the RBA may rise to 3 percent.

The official RBA cash rate today is 1.35 percent. This is certain to maintain investment market volatility through to the end of calendar year 2022, at least.

On the employment front, the picture is much brighter. The unemployment rate in Australia today is at a 48 year low of 3.5 percent. This infers that the likelihood of an economic recession in Australia is low.

The other reason why the Australian economy is unlikely to fall into recession is the boost from high global commodity prices for iron ore, coal, copper, gold, wheat, and LNG exports.

Recessions do not naturally occur when the job market is tight and commodity export prices are at boom time levels. The resilient Australian economy is in a strong position to weather the interest rate rises in the months ahead.

An investment strategy for the times

Rising interest rates have a negative impact on investment valuations and on markets generally. This is because the higher the interest rate, the lower the amount of capital needed to generate the same level of income.

This lower amount of required capital explains the lower net present value of income producing assets such as dividend paying shares and income producing properties, in times of rising interest rates.

This in turn explains why asset valuations will undergo a downward valuation adjustment when interest rates increase. This causes asset price volatility, which experienced, long-term investors liken to the price of an admission ticket to an event……………or an opportunity. Moreover, because investors, particularly in the stock market, have different time horizons, and when combined with investment market volatility, this creates market mispricing……………or an investment opportunity.

Building higher cash balances from the commencement of a market decline after a period of sustained rises, is a sound investment strategy, by avoiding selling assets at a material discount.

This does not mean going to all cash at the first sign of a market correction, for several reasons. Firstly, value is not presented just because an asset price has fallen. Price information is free and the reason it is free is because it contains no information about value.

Secondly, going to all cash requires two correct decisions – when to get out and when to get back in, and in the interim making enough money to cover lost income and taxes.

Perhaps you can time it perfectly – most people can’t. Yes, someone will time it perfectly – just as someone wins Lotto each week. But that doesn’t mean it’s a good strategy.

A more appropriate strategy is to document a carefully considered investment plan for the short-term, medium-term and long-term, with the support of an independent, licensed investment planner.

This ensures that investment decisions are objective, logical, based on reasoning, and supported by clear thinking, and are free of emotional bias. A licensed financial planner is able to put issues in context, rather than take cues from short-term market movements as markets adjust to changing economic circumstances.

Importantly, these market conditions and related challenges are not new, and so a financial planner is best positioned to protect investors’ capital by creating a portfolio that is resilient against many different outcomes.

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