FriWith this understanding, better investment decisions are made. Now and in the future. Below I try to get to the gist of what happened.
A well-functioning financial system should channel scarce savings into the most promising investment opportunities. However, due to the glut of savings and the printing press of central banks, too much money has flowed and investments have been made in opportunities that perhaps should not have been funded. If a company has received billions in investment but will never be profitable, then that money has been wasted and this is hurting long-term economic growth. Especially in a steeply rising interest rate environment, many of these companies will not survive.
Related to the above and as a further consequence of having too much money in circulation, investors are willing to accept lower returns on a risk-adjusted basis. Because in the end, the supply of investment (those who invest) and the demand for investment (those who require investment) are also subject to the forces of supply and demand. The decline in the required return is manifested by the increase in the prices of assets: stocks, debt securities, prices of residential and commercial real estate, etc. In search of yield, some investors are willing to invest in high-risk opportunities with poor fundamentals, increasing risk in the financial system as a whole.
Of course, inflation has been one of the main headlines of the past few months and the top concern for many consumers. All the money circulating around increased demand for a limited supply of services and products, which due to supply chain issues exacerbated by the war in Ukraine, Covid, staff shortages in various sectors and the underinvestment in key industries such as oil have led to significant inflation.
Central banks around the world have started pulling money out of the financial system, leading to higher interest rates and a reversal of what I’ve described above, if successful. I like to think it’s better compared to an earthquake hitting the financial world: buildings with solid foundations (i.e. good quality businesses) will continue to hold, while those that were built in haste and in the hope that earthquakes will never happen (i.e. businesses with no prospect of profitability), will collapse. Risk is repriced and required returns increase, driving down prices even of good quality companies.
One of the tasks of central banks is to smooth the economic cycle, which they failed to do collectively because they acted too late in proclaiming for a long period last year their belief that high inflation would be transient. The consequence is that now they have to apply the brakes hard, as the Federal Reserve is doing in the United States, which will perhaps lead to a global recession. The European Central Bank has the additional problem that raising interest rates can topple one or more of its member states and therefore there is a limit to how hard the brakes can be applied, which means that inflation may be a more persistent problem and that the euro may potentially weaken further on a comparative basis against the US dollar.
What to do now?
As a financial advisor, each client is unique and therefore deserves tailor-made advice. However, I can provide some general guidelines that may be helpful in determining a sound investment strategy:
• Don’t try to figure out where the bottom of the market is, because that would be a wild ride. Statistically, it is virtually impossible to time the market perfectly.
• Try to exclude emotions from your investment decisions. Greed is not good when there is a bull market, nor is fear a constructive emotion in a bear market.
• Focus on the fundamentals. For an investment in stocks, ask yourself which company will still be profitable in ten years and what is the current valuation of this company? Many excellent companies have also lost value in recent months and can therefore currently be valued at very attractive prices.
• Remember today by writing down what happened and re-read it in the next bull run. Don’t convince yourself that next time it will be different, because it won’t.
• Always build your investment portfolio so that it can withstand a market downturn. Be very careful in using leverage, diversify your portfolio and, if possible, only invest excess savings, so you don’t need to sell assets at depressed prices.
Curious to know what our advice would be tailored to your situation? Contact us in the Lisbon office for a no obligation discussion on what we can do for you, especially in these times.
Blacktower Financial Management (+351 214 648 220) or email firstname.lastname@example.org