Calendar year to date, the stock and bond markets have produced some of the worst returns on record, which is unusual because bonds and stocks are typically negatively correlated. In fact, this has only happened two times over the past 96 years, as illustrated in this chart. Even gold, commodities and property have lost value this year. It’s really been a horrible market for investment returns.
I discuss the key risks that have driven markets lower below, as well as highlighting the investment opportunities that exist as a result.
How high will interest rates rise and for how long?
I think the biggest factor that is creating the most uncertainty is what the terminal cash rate may be i.e., how high will central banks have to raise rates to reduce inflation. I don’t think the market will begin any sustainable recovery until the terminal cash rate becomes clear and ascertainable.
If the terminal cash rate turns out to be lower than what the market has priced in, then it is possible that markets could rebound strongly. In Australia, the market has priced in a terminal cash rate of 4.0%, so it’s entirely possible that the market has over-sold, since no economists expect the RBA to raise rates by another 1.40%. For example, the big 4 banks forecast the terminal cash rate to be 3.1-3.6% which is an increase by another 0.5% to 1.0% over the coming 6 to 9 months.
In the US, its equivalent cash rate is currently set at 3.00-3.25% and the market is expecting a terminal rate of between 4.5-5.0%, so it seems the US Fed Reserve has a lot more work to do than the RBA does in Australia.
My point is that until we see successive data that confirms inflation has begun returning to normal levels, the market cannot accurately price in an accurate terminal cash rate.
Will there be a recession? If so, how deep?
In response to rising inflation, central banks have hiked interest rates faster that anytime in history.
Normally, when a central bank wants to tighten monetary policy, it does so less aggressively so that it can measure the impact that higher rates is having on the economy. This more measured approach allows central bankers to adjust their approach to ensure it doesn’t raise rates too far and cause a recession i.e., slow economic growth too much.
Given most economic data lags by two to three months, central banks are really flying blind at the moment. That is, they won’t be able to measure the impact of current interest rate settings until the end of this year or start of 2023. As such, there’s a risk that they raise rates too fast and too hard and send the economy into a recession. How deep that recession is will depend on how much they overtightened rates. And that is yet to be seen, but it’s a risk that markets are contemplating.
Will there be a nuclear war?
Of course, the most significant geopolitical risk is Putin using nuclear weapons in its conflict with the Ukraine. If it does, the Western alliance will have to respond and of course that could spiral into World War III.
I am certainly not a geopolitical expert, so I cannot offer any commentary about this risk other than to say it’s a risk factor that must be impacting markets.
What damage will energy prices inflict
The price of domestic energy (gas and electricity) is rising around the world, especially in the UK where prices have more than doubled over the past 12 months. These price increases are likely to cause economic pain for residences of northern hemisphere countries as they approach winter.
Residents therefore must tackle higher energy prices at the same time as higher interest rates, which further increases recessionary risks. If a recession did occur, it’s entirely possible and appropriate that central banks could pivot and begin cutting rates to stimulate the economy again.
Many of these risks are priced into the market
If there’s one thing that markets dislike, its uncertainty. When faced with uncertainty, often markets tend to fully price in risks i.e., the economic impact of these risks are arguably priced into the market.
For example, the US share market has fallen 25% since the start of January 2022. Whilst a fall in company earnings have contributed to some of these falls, the majority has been driven by a reweighting of valuation multiples. This is how markets accommodate risks.
It is important to highlight that a volatile market can create investment opportunities, particularly if markets have overcorrected or if some of these risks do not materialise as expected. The table below sets out average 10-year expected investment return ranges for various share markets. Statistically, according to the generally accepted and peer-reviewed modelling theory, there’s a 70% probability that returns will be between the stated ranges.
| Share market | Future expected returns |
| Emerging markets | 9.5% to 15.7% |
| Australia | 8.4% to 13.0% |
| Europe | 7.2% to 11.8% |
| UK | 5.3% to 9.5% |
| US | 4.1% to 8.9% |
| Japan | 3.7% to 9.0% |
| International index (developed markets) | 3.3% to 7.0% |
These projections are useful because they highlight the markets that exhibit the best opportunities for future returns and which markets to underweight/avoid.
Use various evidence-based, low-cost methodologies to access these share markets
Different rules-based indexing methodologies work better in different markets.
In a growth market, traditional market capitalising indexing works very well.
In a market that is experiencing a valuation reweighting and economic headwinds, alternative methodologies that break the link with share price typically produce better returns i.e., index construction that isn’t based on a stock’s current share price.
Different indexing strategies can accommodate different risks and expose your portfolio to higher returns. For example, Research Affiliates model suggests value will outperform growth by 2.5% p.a. over the next 10 years. Of course, there are no guarantees, but this evidence-based approach helps us weight portfolios towards these methodologies.
Look for the opportunity
On the face of it, share markets look like an endless stream of bad news. And it is entirely possible that if you invest today, you may not be better off 12 months from now. However, if you take a long-term approach, adopt evidence-based methodologies that are low-cost, then it’s likely that in 5 to 10 years you’ll look back at 2022 as a time that offered great investment opportunities.
