Rethinking risk management in a volatile market in 2022
With the world counting on a widespread crisis in the cost of living and the Federal Reserve all but promising further interest rate hikes, it is clear that some of the problems posed by inflation are not going anywhere anytime soon. The continued market volatility of 2022 has been defined in large part by the highest levels of inflation seen in decades, disrupting the economy as well as the ability of investment professionals to consistently deliver above-average returns. for the customers.
Given the current state of the market and its outlook for the foreseeable future, investment firms should consider a significant shift in their approach to portfolio management. After several years of increasing, reliable returns and seemingly limitless growth potential, the investment sphere has long awaited a move towards pragmatism and risk reduction.
However, effectively preserving client assets in this environment requires an understanding of the myriad factors that brought us here in the first place.
Chief among them was the pandemic: as COVID-19 reached an inflection point in 2020, markets plunged as collective fear gripped the financial sector and the world at large. As businesses closed and people lost their jobs, unemployment rates soared overnight. Though hard to remember now, fears of a full-scale recession were pronounced even amid momentary market swings in 2020.
However, as conditions stabilized and the economy adjusted to this new reality, the market rebounded. Businesses have gone virtual, families have stayed home, businesses have received COVID-19 relief funds, and people have learned to transact in a socially distanced way. The Fed’s emergency intervention and injection of trillions of cash proved particularly crucial: as interest rates were cut to zero, funds were sent to individuals, and financial instruments – such as government, corporate and municipal bonds – were bought, the economy suddenly found itself flushed with cash. The Fed’s injection of cash made consumers feel comfortable spending again and gave investors access to capital that was then put back into the market.
For many people, this stabilization of the market and this flood of liquidity provided by the federal government served as the proverbial green light from the Fed to buy risky long-lived assets: a considerable amount of this new wealth was spent in new volatile asset classes such as crypto, meme stocks and tech investments. Even with lingering issues such as supply chain issues, the economy had seemingly found a place of relative stability in a volatile world.
But as 2021 progressed, keen observers began to suspect that the market was in for a correction. Shares of companies with very little earnings or even sales fared significantly better than entities with predictable earnings and cash flows, making it difficult to determine the fair value of more speculative companies in the market. , a tricky prospect made even trickier by low interest rates. With more and more speculative stocks providing an overvalued measure of market conditions, many felt too comfortable diversifying with excess capital. As more investors took risks without realizing they were putting their portfolios at risk, some companies took steps to reorganize their assets and protect themselves from stocks that are particularly sensitive to high interest rates.
Flash-forward to 2022, and any notion of economic stability is all but gone. The latent problems facing the market have since become readily visible, with record inflation and stagnant growth as the most obvious symptoms. Additionally, exogenous variables such as the war in Ukraine and other supply chain issues brought about by new waves of COVID have exacerbated existing issues while the Fed has completely pivoted on its earlier reluctance to raise rates. interest rates above zero and struggled with an ever-expanding balance sheet. . Now facing raw nerves in the financial sector and beyond, the Fed’s aggressive interest rate hike has only amplified the worries swirling around the economy.
Now, with two straight quarters of falling GDP amid gloomy expectations of lower profits, corporate margins and higher interest rates, investors are wondering how to reorient their portfolios and salvage their assets. The bitter truth is that the window of opportunity to cushion assets against economic volatility closed several months ago. As the market undergoes a full price overhaul in anticipation of interest rates hitting 3.75% or 4% by 2023, trading is expected to slow. Neither inflation nor the Fed’s fight against it is far from over, leaving many investors stuck in a never-ending rut.
However, it is still possible to change course and reorient portfolios around long-term strategies. Given the current economic outlook, it is essential to keep relative performance in mind – the general slowdown makes it difficult to imagine building a portfolio where investors will realize significant returns. While this development will prove disappointing to many, the reality is that relying on fixed income as part of the 60/40 model is no longer viable or reliable for most portfolios. Instead, investors and companies should consider turning to strategies that prioritize dividends, fundamental growth, dividend growth, and qualified tax efficiency. Buying shorter-duration, consistent, dividend-paying stocks brings free cash and reduces risk, a winning strategy for all investment metrics.