Financial markets did not reflect the underlying current strength of the global economy. Instead, prices of riskier assets such as stocks and low-rated corporate bonds declined, and those of less-risky assets such as government bonds rose. Markets reacted as though a recession is imminent.
Despite their late-year rally, bonds couldn’t escape the inherent limitations of a low interest rate environment, and the broad Canadian bond universe return for the year was only 1.4%.
Commensurate with the negative stock market returns and low bond returns, the Compass returns for the year ranged from about a negative half-percent for the most conservative portfolio to just below negative six percent for the most aggressive.
Stock prices often fall and rise in advance of the broader economy, but also move independently of the broader economy. To quote Paul Samuelson, “the stock market has predicted 9 of the last 5 recessions.”
Instead of attributing the late-year stock price decline to “investor irrationality”, we should also acknowledge that economic indicators measure only the past, not the future, and can deteriorate quickly. For example, in the last two recessions US job growth went from positive to significantly negative in only four months. Furthermore, because North American central banks are raising their target interest rates and “tightening” monetary policy, the chance of a recession occurring is higher than if they were doing the opposite.
Having said that, there are several reasons we don’t believe the broad North American economy is headed into recession. First, neither the Canadian nor the US central bank has expressed any concern about excessive inflation. Rather, both have repeatedly expressed that the goal of the current interest rate increases is to “normalize” interest rates, i.e. to wean the public off the abnormally low interest rates required to counter the 2008-09 global financial crisis and Great Recession. Both central banks want to get interest rates back to neutral levels, not to the high levels - occasionally needed to combat excessive inflation - that can also trigger a recession.
Secondly, the financial system is also significantly stronger now than it was on the eve of the 2008 financial crisis. Banks are far better capitalized, and house prices are not stretched relative to incomes.
Finally, interest rates remain low by most standards. Borrowers and bond investors represent different sides of the same coin: a high interest rate for the former represents an attractive interest rate for the latter. As investors, we do not find the current interest rate environment very attractive. For example, at year end the 1.96% interest rate of the 10-year Government of Canada bond was lower than the Bank of Canada’s inflation target of 2%.
It is inevitable that at some point the economy will slow at least somewhat, though it need not “fall off a cliff” as it did in 2008-09. Equally important is that at some later point, it will accelerate. The size and timing of both will only be determined well after the fact.
If predicting the exact timing of the economic slowdowns is a mug’s game, and if sizeable stock price movements occur even outside of recessions, then an investor’s most appropriate plan of action is to not spend time and energy trying to predict the unpredictable. Instead, the path to success involves investing in a portfolio with appropriate return and risk characteristics, and then letting time work to one’s advantage.
On average and over time, stocks have generated higher returns than bonds, which in turn have generated higher returns than cash left in bank accounts. The benefits don’t come without strings attached: the last few months provided a cogent reminder that stocks’ higher returns are also accompanied by higher volatility, which can come out of the blue. But as we’ve said many times in this space, and will continue to say, don’t let the inevitable short-term gyrations distract you from your long-term journey to investment success.
Cheers to you in the New Year!