A well-functioning financial system should allow scarce savings to be directed towards the most promising investment opportunities. However, due to the savings glut and the printing press of the central banks, too much money has been flowing around and investments have been made into opportunities that perhaps should not have been funded. If a company received billions of investments but realistically will never be profitable, then that money has been wasted and it is detrimental to economic growth in the long-term. Especially in an environment of steeply rising interest rates, many of these companies will not survive.
Related to the above and as a further consequence of having too much money flowing around, investors are willing to accept lower returns on a risk-adjusted basis. Because in the end, investment supply (those that invest) and investment demand (those that require investment) is also subject to supply and demand forces. The lower required return is manifested by the increase of prices of assets: stocks, debt instruments, the price of residential and commercial property, etc. In search of return, some investors are willing to invest in high-risk opportunities with poor fundamentals, increasing the risk in the financial system overall.
Of course, inflation has been one of the main headlines over the past months and the primary concern for many consumers. All the money flowing around increased demand for a finite supply of services and products, which due to supply chain issues exacerbated by the war in The Ukraine, Covid, personnel shortages in various sectors and underinvestment in key industries such as oil have led to significant inflation.
The central banks worldwide have begun taking money out of the financial system which leads to higher interest rates and a reversal of what I described above, if successful. I like to think it’s best compared to an earthquake hitting the financial world: the buildings with solid foundations (i.e. good-quality companies) will continue to stand, while those that have been built in haste and with the expectation that earthquakes will never happen (i.e. the companies with no prospect of becoming profitable), will collapse. Risk is re-assessed and required returns rise, pushing prices down, even of good-quality companies.
One of the tasks of the central banks is to smoothen the economic cycle, which, one can argue, they have collectively failed to do as they acted too late proclaiming for a long period last year their belief that significant inflation would be transitory. Consequence of which is that now they have to slam the brakes hard, as the Federal Reserve in the United States is doing, which possibly will lead to a global recession. The European Central Bank has the additional problem that raising interest rates may topple one or more of its member states and hence there is a limit to how hard the brakes can be applied, meaning that inflation may be a more persistent problem and the Euro can potentially weaken further on a comparative basis to the US dollar.
What to do now?
As a financial advisor, each client is unique and hence deserves bespoke advice. However, I can provide a couple of general guidelines that may be useful when determining a sound investment strategy:
• Do not try to determine where the bottom of the market is, as this will be a fool’s errand. Statistically, timing the market to perfection is practically impossible.
• Try to leave emotions out of your investment decisions. Greed is not good when there is a bull market, nor is fear a constructive emotion during bear market times.
• Focus on the fundamentals. For investment in shares, ask yourself, which company I expect will still be profitable ten years from now and what is the current valuation of that company? Many excellent companies also lost value in the past months and hence may be very attractively priced at the moment.
• Remember today by writing down what has happened and read it back to yourself during the next bull run. Don’t convince yourself that next time it will be different, because it will not be.
• Always build your investment portfolio so that it can withstand a market reversal. Be very careful with using leverage, diversify your portfolio and, if possible, only invest excess savings, so you do not need to sell assets at depressed prices.
Curious what our bespoke advice for your situation would be? Contact us in the Lisbon office for a no-strings-attached discussion of what we can do for you, especially in these times.
Blacktower Financial Management (+351 214 648 220) or email email@example.com