The panic that we have witnessed recently can be largely attributed to one thing; expectations of rising interest rates in major economies such as the US. Base levels are expected to rise because inflation will increase significantly in 2018 and this is having an impact on investments across portfolios, but the savvy investor will see opportunity where others see fright.
The start to equity markets in 2018 had been strong, but volatility; marked by daily swings on the Dow Jones Industrial Average in excess of 1,000 points, has returned to the global capital markets. The trigger to this was better than expected employment data in the US, and the strong pick-up in wage growth. These have raised expectations that the pace of interest rate hikes will rise and cause treasury yields to rise faster. Further, the US government will need to raise more funds to finance the tax reductions following President Trump's Tax Cuts and Jobs Act, which became law in December 2017. This is also the same period when the Federal Reserve will be unwinding its balance sheet instead of buying new bonds.
Rising interest rates mean that there is a different asset class; namely fixed income, that is expected to provide good returns and reduce the previous high dependence on equities for growth. Further, higher bond yields reduce the attractiveness of investments in equities due to a bigger discounting factor for valuing companies.
This is because higher interest rates reduce the perceived value of future corporate earnings and put pressure on profits. Rising interest rates also mean that it is now more expensive to borrow money to invest in the stock markets.
The era of cheap money, seen for much of the past 10 years, is therefore increasingly coming to an end. Also, when stock markets fall and there is a lot of leveraged money in the stock markets, often driven by quart funds, the fall is more severe and faster.
Passively managed funds (mainly ETFs) and by that account, funds that cost less than actively managed funds (funds run by fund managers), are the most impacted during market falls. This is largely due to automated transactions by these index and sector tracking funds. In scenarios like this, investments should go into portfolios built of actively managed funds and run by fund managers who are far more capable, and better at reacting to global market conditions and identifying investment opportunities.
Managers of these actively managed funds do charge higher fees than a passively managed fund, yet so much focus remains on the "cost of the fund" that investors often forget that there is a reason why actively managed funds cost more money in the first place.
On the upside, rising interest rates and inflation can also be a reflection of strong economic growth, increasing wages and more global trade. Investors need to remember that the fundamentals for global economies remain strong and corporate profits will continue to rise in the short-term and medium-term. As a result, the correction can be seen as a great buying opportunity for investors taking a longer-term view on quality companies, especially the ones that now have been brought down to sensible valuations.
Market corrections based on these economic and fiscal sentiments should not be a reason to panic.
This market tantrum can be seen as a starting point for events a year or two in the future when the actual impact of rising inflation will be seen, and all the current positive economic forces will not be able to counter the impact of tighter job markets and rising wages. For many investors a correction is simply a sale. Most smart investors have been window-shopping these past few months, looking at the stock prices and then walking away. All the time expecting that a correction is around the corner and when that correction comes, they would swoop in and buy the stocks at much better value and then hold onto them for long-term capital growth.
These are the times when investors must avoid panic selling and resisit the urge to get out of stock markets because they want to cut their losses.
During the lifecycle of investing, such market corrections present great buying opportunities always. Some of these corrections are deep and some last a long time, which can test an investor's patience. But, as long as an investor is confident of the growth areas and has a strong rationale in those growth areas (as well as the research to back this up), there should be nothing to fret about. Put simply; the secret to long-term wealth creation is to stay invested, wait for corrections, deploy cash, never panic and to continue to believe in one's investments.
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