A contrarian approach to inflation, interest rates and the markets

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Investors are gearing up for another year of market twists and turns as the Omicron variant is already making 2022 feel like a repeat of 2020 (or even 2021). Throw in fear about hiking inflation and interest rates, and it’s understandable that the talk is turning to how to best hedge against all the anticipated volatility. I have a different take on what’s about to unfold. Here’s what I think:

Inflation is not a cause for concern

Inflation is approaching 5% higher than we’ve seen in decades. While it’s expected to continue to rise in the coming months, I believe by the end of March 2022, it’s going to start to fall.

Why? The reason inflation climbed in the first place was because of the impacts of COVID-19 on labour forces and supply chains. With businesses having to slow or stop operations, and people getting sick and/or leaving the workforce, demand has outstripped supply: pushing costs up. That’s just economics 101.

While the Omicron variant makes the daily headlines, the reality is: With each new variant—from Alpha to Delta to Omicron—economies and stocks have rebounded faster. That’s why the markets enjoyed double-digit growth in 2020 and 2021.

With vaccination rates rising globally and nearly 80% of the Canadian population fully vaccinated, experts say we are at a point when the pandemic is transitioning into an endemic phase—something we are just going to live with.

This is good news for supply chains, which will return to business as usual. Growing supply will better meet demand, returning inflation to lower levels. The Federal Reserve Bank of New York Global Supply Chain Pressure Index suggests that supply chain issues have peaked and soon goods will be flowing more freely between regions.

Interest rates aren’t increasing enough to impact everyday life

While the Bank of Canada and The Federal Reserve in the U.S. have each announced interest rate increases in 2022—a typical tactic to fight inflation—the reality is the increases are minimal and build on rates that have been kept at historic lows for more than a decade. The planned increases will not slow down the demand for everyday items, like milk and eggs. They may slow down the demand for bigger-ticket items that could require loans, such as cars, housing and business investments.

The economy and markets can rise, along with interest rates

Central banks have created this environment of lower-for-longer interest rates, but is that healthy? I don’t think so, particularly if you are a low-risk investor or a retiree who would like to be able to put their money into bonds and guaranteed investment certificates (GICs) and earn 3% and 4%. Instead, they have to invest in the stock market to achieve returns that will help them meet the cost of living.

In my opinion, a healthy economy happens when interest rates are not at emergency low levels in order to stimulate investment. We haven’t been in an economic emergency since we recovered from the financial collapse of 2008, which triggered governments to lower interest rates.

It’s time for central banks to start raising interest rates to find the balance that allows fixed-income investors to earn enough from their low-risk investments—bonds, GICs, high-interest savings accounts (HISAs)—to exceed inflation. Investors should have an alternative to investing in the markets to grow their wealth. Rising interest rates offer that alternative.

The way forward for fixed-income investors is with balance

Instead of building a traditional fixed-income portfolio, I suggest low- to no-risk investors direct a portion of their portfolios (however much is comfortable) to dividend-paying equities. This way, regardless of whether or not the stock price dips, the investor is still earning money. The rest can then go into fixed-income investments such as government and corporate bonds, mortgage-backed securities, etc. 

While these latter investments will have low yields, you can boost overall performance with dividends and the potential for capital gains. This helps mitigate risk, preserve wealth and provides a rate of return that at least matches the cost of living.

The wrong question: Should I invest in value stocks or growth stocks?

People tend to define value and growth stocks based on price. Value stocks are cheap. Growth stocks are expensive. I disagree with this characterization. I believe investors should always look for value—even in growth stocks.

The biggest tech companies in the world are typically viewed as “growth stocks” because of the huge and growing revenues and high stock prices. But I also view them as value stocks because the stock prices are trading at many multiples of earnings. I look for stocks that represent “Growth at a Reasonable Price,” or GARP. These stocks fall somewhere in the middle.

The question investors should be asking is: Can stocks continue to rise in an environment with potentially higher inflation and increased interest rates? The answer is yes.

My final thoughts

So, what does all of this mean? Investors will likely find 2022 to be a bit more challenging than 2021. But taking a balanced approach to your portfolio will help you enjoy another positive year of growth. The key is to adjust expectations. In 2021, the S&P 500 grew by approximately 27% and the Toronto Stock Exchange was up almost 22%. In 2022, I think the markets will still increase, but at more traditional average levels of between 6% and 9%. And that’s just fine.

Allan Small is the Senior Investment Advisor at the Allan Small Financial Group with iA Private Wealth (allansmall.com) as well as the author of How To Profit When Investors are Scared. He can be reached at allan@allansmall.com.

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