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The Biggest Investment Risk Today

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At Endeavour Wealth Management, we are very clear with clients that our ability to predict the future is limited. With that said, although we can't predict exactly what is going to happen in the future, there is merit in understanding where we are today. We can use this information to help inform us of where we MIGHT be heading and to hopefully plan accordingly. So the question is, where are we today? And where might we be going? Before we look out into the future let's take a look at where we've been.

Where We Have Been in 2020

2020 was one hell of a year. Covid-19 rapidly spread across the planet becoming the worst pandemic suffered in over a century. In the US, the COVID death toll has exceeded the number of American lives lost in World War II. In Canada, GDP shrunk 11.5% in quarter 2 of 2020 and 5.4% for the entire calendar year, the steepest annual declines since comparable data was recorded. In the US, the Federal Reserve increased its balance sheet by $2.7 trillion and Treasury funded $4 trillion in grants and loans. Here in Canada, it's estimated the government ran a deficit of $354 billion last year with another $154 billion deficit expected for 2021. We saw the S&P 500 fall 33.9% from pre-pandemic highs over the course of 32 days. The index followed that up by gaining 67.9% from the low finishing 2020 with a gain of 18.4%.

Moving Forward

It's astonishing to look back at what we've gone through to date. However, for investors, the reality is that the path forward is all that matters. On the positive side, it seems very likely that both the Canadian and US economy are healthy and poised to perform well over the immediate term. Economies are continuing to re-open and recover, which is expected to accelerate as more and more people are vaccinated. Governments and central banks have shown extraordinary fiscal and monetary support and have signaled that they will continue to do so as long as required. Both in Canada and the US, consumers are reporting record levels of increased personal savings, with many of these consumers using these excess savings to even pay down portions of their household debt. Sounds like a half-decent economy considering everything mentioned in the first half of the previous paragraph.

Potential for Rising Interest Rates

On the flip side, experts continue to sound the alarm over what I believe is the biggest risk to the economy, which is the potential for rising interest rates. For investors, interest rates have steadily declined over 40 years which has been a massive tailwind for pretty much all asset prices. Stocks, bonds, and real estate have all benefitted from near-zero interest rates with many asset classes reaching historic highs. This makes sense. As the risk-free rate declines (represented by 10-year treasury bonds), many investors will move their capital to riskier assets to seek out higher returns. When this occurs the values of these riskier assets increase, which inherently means future returns of these risky assets are lower than they were before. So on the one hand we have an economy that seems to be on decent footing considering what we have been through.

Massive Increases are Happening

On other hand, we've seen massive increases in almost all asset values, with markets that seem ripe for reversal if interest rates were to rise. One of the prevailing beliefs out there is that rates cannot rise anytime soon because of the damage it would cause. Both politicians and central bankers have signaled they will continue to support citizens until the economy has recovered. The message to this point has been it is better to provide too much support than it is too little. Tough to argue against that, but even if too much support is better than too little, that does not mean too much support comes without its own risks.

What is Inflation?

Enter inflation. Inflation, which measures the increase in prices of goods and services is extremely hard to predict. High inflation is a sign of an overly hot economy. Although modest inflation in the range of 1-3% is viewed as a good thing, too much of it can be very bad. The higher inflation runs, the quicker the dollars you have will lose their value.

Although we've yet to see significant levels of inflation to this point, it is far from guaranteed that it will stay that way. One might argue we are already seeing inflation poke its nasty head out in areas like building materials, groceries, and the gas you put in your car. What makes the possibility of this occurring even more likely is the fact that governments are actively trying to achieve inflation and have suggested they are even comfortable letting it run hot in the short term. If rising rates are the gun that might kill the economy and asset values, runaway inflation would be the villain who pulled the trigger.

I say this because, for governments and central banks to rein in runaway inflation, interest rates must rise to slow the speed of money flowing within the economy. So even though the Federal Reserve has suggested rates will not be going anywhere in the near term, runaway inflation could change this outlook in the blink of an eye. If inflation ever did pick up faster than expected, it would send shock waves through all asset classes, even those that most would consider "safe investments" like government bonds.

Inflation is impossible to predict. Since 2008, media pundits, economists, and professional investors have been calling for higher inflation and are still waiting to be right. Now although inflation is hard to predict, as advisors we'd be stupid to ignore the possibility of runaway inflation because it comes with significant consequences if you're not prepared. The reality is runaway inflation would be devastating to most asset values and could spell big trouble for investors who are at or nearing retirement.

Plan Not Predict

Although we can't predict exactly what will happen, we can plan. For us, this has meant reducing overall exposure to fixed income assets and exploring alternatives with less correlation to the movements in interest rate prices. As it relates to our stock positions, we are always looking for businesses that have pricing power or businesses with the ability to continue to grow cash flows with lower levels of capital spending. These types of businesses have better inflation protection built-in and would weather the storm a lot better than businesses that couldn't raise prices or businesses that have to spend capital just to maintain existing production levels.

Money to Compound

We could be entirely wrong and never see inflation. That's not the point. Part of successfully compounding your money over time is about having money to compound. Ignoring inflation could be disastrous to a portfolio that hasn't been positioned with that possibility in mind. As stewards of our client's wealth, we'd rather give up some returns now and build proper protection in the chance that inflation does appear because we know this is what allows our clients to continue to compound their returns.

According to the famous investor Howard Marks, who inspired this blog post, Because the primary risk lies in the possibility of rising inflation and the higher interest rates that it would bring, I think portfolios have to make allowances: even though we can't predict, we should prepare."

- Brandt Butt, Investment Advisor, CIM

Brandt Butt is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Brandt Butt who is an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.

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