Invasion from Russia and Inflation

Due to the uncertain times that are upon us we thought we would come out to you about the current Ukraine invasion and inflation.  Both are impacting on global markets.  You may have noticed the impact on your Kiwisaver or investment portfolio you hold with us.  We discuss the impacts of the invasion and inflation further on in this document.

We have been in contact with the fund managers we work with over the past week to discuss their stance on the Russian invasion.  All of our fund managers had small or no holdings in Russia.  Those that still do are working towards divesting any assets with Russian holdings.  The highest holdings we could find were .32% in a high growth portfolio.  That equates to 32 cents for every $100 invested.

Impact on Share markets

When you invest, own property, shares or bonds, you are going to experience some kind of geo political event or crisis.  Since World War two, we have experienced events as such the Cuban Missile Crisis, the Vietnam war, Iraqi invasion of Kuwait, 9/11, the collapse of the Soviet Union.

Through all of these, the investment markets have behaved as they should.  With increased uncertainty, buyers require a higher expected return for their share purchase.  They achieve this by buying them at a lower prices.  Sellers, meanwhile are happy to accept a lower price in order to reduce their uncertainty.  The markets match these buyers with these sellers.  So, through these periods of uncertainty the markets have functioned well.  It is the participants that have been spooked!!

While we do not know if markets will go lower from here, history has shown that over the long run, selling after the market falls is an overwhelmingly poor strategy, and one we encourage our clients to avoid.  However, every investor is unique.  We encourage you to get in touch if you want to discuss your situation.

Normally, when share prices are volatile there is a flight to “safer” assets such as property, bonds, and cash.  These assets are seen as less volatile and become more attractive during periods of uncertainty.  Usually, when assets become more attractive that drives the price up.  So assets like bonds are seen as a natural hedge (protection from loss) against shares.

Impact on Bond Markets

Enter inflation.  Inflation has been fairly stagnated for quite some time.  Inflation (the general increase of goods and services in an economy) can impact on the value of most asset classes (shares, property, bonds, cash) including bonds and cash.  As a consumer, you have less purchasing power (what you could purchase for $1 you can no longer) so your cash in the bank is worth less, your salary or wage is worth less.  That also means you don’t have the same ability to borrow money as you once did.  This is because you are spending more to buy the same things, and you’ll find interest rates have moved up, also increasing your borrowing costs.

Why do interest rates move up during inflation?  You as a consumer can no longer buy as much as you previously could.  Think about that if you have also lent money.  If the money you get paid back from the interest charged on that loan is worth less, you want more money.  The way to achieve that is to put the interest rate up.  The impact is that people borrow less and spend less.  Which means suppliers either have to reduce their production to meet less demand or drop their prices.

So how does inflation affect bonds?  Bonds are a loan from either the government or a business.  They borrow money at a set interest rate for a period of time.  Similar to a term deposit.  They are viewed as safer than shares, as if the business goes belly up, they pay their creditors (the person that lent the money) before their shareholders.

The difference with a bond is that, unlike a term deposit it can be bought and sold on an exchange at any time.  So, if you bought a bond paying 2% for 2 years and want to sell it after 1 year but bonds are then selling at 4% for 1 year, you have to discount the value of your bond to be able to sell it and compete with bonds selling with higher interest rates.  This means in a rising interest rate market bonds paying lower interest rates are discounted in value.  This impacts the value of your portfolio in the short term.

The good news for bond holders is that yield curves (the difference in pricing of different terms of bonds) is flattening out.  The yield curve is often used as a predictor of interest rates.  A steep rising yield curve means interest rates are predicted to go up, a downward sloping yield curve means that interest rates are heading down.

Conclusion

Investing is a long term game.  Investors are rewarded for their discipline.  History has shown that investors that have stayed the course have been rewarded.

From 1970 to 2020, which includes the gulf war, Iraq war, 9/11, rampant inflation in the eighties, the GFC and the oil crisis, there have been many market fluctuations.  During the GFC some share indexes halved.  Those that pulled out crystalised their losses.  Those that stayed in:

New Zealand shares have delivered a 12.6% annual pre-tax return.  $10,000 invested in 1970 was worth $3,851,207 in 2020

World shares have delivered a 11% annual pre-tax return.  $10,000 invested in 1970 was worth $1,838,142 in 2020

Australian shares have delivered a 10.8% pre-tax return.  $10,000 invested in 1970 was worth $1,700,510 in 2020

World bonds have delivered an 8.4% pre-tax return.  $10,000 invested in 1970 was worth $567,932 in 2020

NZ bonds have delivered a 7.7% pre-tax return.  $10,000 invested in 1970 was worth $401,324 in 2020.

Inflation has averaged 5.7%.  $10,000 in 1970 bought you the same as $158,884 in 2020.

Returns and values courtesy of Booster Investment Management.

Disclaimer:  This newsletter is meant to be informative and engaging, hopefully not a cure for insomnia.  Please don't take this as personalised financial advice.  Discuss your situation with an Advisor.  This is where I need to say past returns are no guarantee of future returns.