Portfolio Issues - Russian Reminder
Sometimes an event comes along that reminds us of what we already know. At the end of February Russia invaded Ukraine, in the largest military operation in Europe since World War II. This is a reminder that in a world full of human beings, we are always subject to unexpected events. The invasion also reminds us that there are people and governments that will trample over others. The world is not full of only nice folks.
Why do we mention this? Because investing is always about making decisions in the face of a fuzzy future. Most European leaders thought they could negotiate with Putin, and that Russia would never invade Ukraine. They were wrong, and now those European countries find themselves heavily dependent on Russian oil and gas at a time when they wish they weren’t.
Investors can use this current event as a useful reminder about diversification, and about considering the limits of what you can know. Like European leaders with Russian gas, anyone who put all their investing eggs in the technology basket over the last few years might want to reconsider that strategy.
You can’t possibly know all that might happen in the world. But you can set up your investments and your finances so that unexpected events don’t wreak havoc.
One other reminder: If the US stock market drifts lower, return expectations for investors drift higher. Why? The long term return for US companies is remarkably stable. Unless you think the US is permanently hobbled by current events, and we don’t, lower prices today translate into higher returns in the future.
“That? I call that my ‘Useful But Annoying’ box. It’s chock full of reminders.”
Market View - Messy
You may have noticed that we go through periods in the markets when one theme dominates: inflation, Covid, war, recession, recovery. The world is always more complicated than that, but investors tend to boil the broth down to a bite-sized spoon full. The current environment seems messier. We have the Russian invasion of Ukraine and what that means for Europe, both in the short and long term; we have the Federal Reserve starting to tighten monetary policy; we have disagreement about how serious a problem inflation is.
In this sort of multi-factor environment, you would expect higher volatility, as investors disagree on how the future will unfold. The VIX, a short-term measure of stock market volatility has jumped from 15 six months ago to the mid-thirties in mid-March (it reached 80 during the crisis of 2008-2009). This measure has little or no predictive value; it is simply a snapshot of the current environment. We expect to see the VIX continue to bounce around.
With inflation running at 7-8%, the Federal Reserve started raising short-term interest rates. How quickly and in what increments they raise is the subject of much debate; and whether they are willing to raise rates high enough to cause a recession. More unknowns.
China continues to be a potential source of instability for world markets, with Covid, a debt-laden property sector, and the government’s attack on publicly-traded Chinese companies. Even one of those factors would create some unease; all three are causing some severe indigestion. The China stock market index is down about 15% this year.
So volatility will continue until there is some consensus on how these various factors get resolved. We don’t know how Russia’s war will progress. We don’t know how the Chinese government will act next. We don’t know how aggressive the Federal Reserve will be in raising rates. There are many possible paths.
Most people are aware that the US stock market has struggled recently, although as of March 31st, the S&P 500 is down only 5.5% for the year. What most people don’t realize is that US bond markets are struggling, too. The interest rate on the US ten-year Treasury bond has risen to about 2.4% per year, not high in historical terms, but high relative to the last ten years. As a result, a typical bond fund is also down about 5.5% this year. Inflation-protected bonds, however, are down only 3% because that inflation protection adds some value.
International stocks are down, too. The Schwab International Stock ETF is down 6%, and the Vanguard European Stock ETF is down nearly 10%, perhaps not so bad considering the Russian invasion.
So if stock and bond prices are both down, does this mean stocks and bonds no longer provide diversification, and we should sell everything and hide in the cellar? The short answer is no. Stocks still provide the best option for long-term growth. There will be times when stocks and bonds don’t provide the diversification we’d like, particularly when interest rates rise. You can offset the impact of rising rates with inflation-protected bonds and dividend-paying stocks, which we have done. Also, it’s worth noting that the interest rate curve has flattened, which means that short-term rates and long-term rates are similar. This implies that investors think rates will not rise too much higher from here. Remember, too, that higher interest rates means more income for you in the future. Finally, in times of crisis, which seem to occur from time to time, bonds absolutely provide the diversification we want.
So, as always, stick with your long-term stock and bond allocation. We don’t know how the future will unfold. There is no shortage of opinions, and people who are unburdened by self-doubt will gladly give you theirs. But heed the Russian reminder: there’s much that we can’t know.
Sources: Economist, Wall Street Journal, Value Line, Vanguard, Applied Finance Group, Schwab