Publish date: 14 January 2022
The new year marks our third year living with COVID. It’s hardly an anniversary any of us will celebrate. But 2022 could mark another milestone – the possible coming to an end of the current era of low interest rates coupled with low inflation. And investors need to take note.
Since the end of the global financial crisis in 2009, sharemarkets globally have largely enjoyed an extended bull run.
Sure, there have been the usual short term ups and downs, but over the last decade, the ASX 200 – the leading Aussie sharemarket index, has recorded capital growth averaging 6.3% annually.
The returns have been even more spectacular in recent years: 9.9% annually over the past three years, and a touch above 12% in 2021 alone.
For investors who are new to the market – and we know the onset of the pandemic saw around 700,000 Australians invest in shares for the first time, it can be easy to assume these sorts of returns are an ongoing feature of equity markets.
But history tells us they’re not.
Rising inflation could be a game-changer
For some time now, we have been living in a low inflation, low interest world, backed by unprecedented government stimulus.
This has been great news for many companies. And the results are reflected in robust sharemarket gains.
However, as we head into 2022, it’s unrealistic to expect more of the same.
With interest rates as low as they are at present, they really only have one way to go – and that’s up.
Inflation is starting to creep higher too. Core inflation has increased to its fastest pace in many years in North America, parts of Europe and the United Kingdom.
What’s the big deal about inflation?
Inflation is generally regarded as a negative for sharemarkets. It leads to higher borrowing costs, higher labour costs, and a rise in materials costs – all of which have the potential to reduce company earnings and profitability.
This doesn’t mean investors should bail out of sharemarkets. Far from it. But it may mean the time has come to shift the pendulum away from passive investing, in favour of a more active approach.
To clarify, exchange traded funds (ETFs), which have soared in popularity in the last few years, typically use a passive approach, aiming to replicate the returns of a given market index.
When the index rises, an ETF should deliver matching gains. On the flipside, when markets dip, an ETF will, by definition, mirror the losses.
Over the past decade, when markets have enjoyed an extended upswing, a passive approach to investing has worked well. However, the gains may not come so readily if the market experiences an inflation-driven slowdown.
Under these conditions, an active approach – one where investors ‘actively’ select individual stocks, has the potential to be a rewarding strategy.
Which approach works best during market slowdowns?
A study by UK investment firm Rathbones, found that active investing is often better able to weather negative return environments compared to a passive approach.
The research also found that when interest rates rise, there can be a widening gap between the best and worst performing stocks. And this environment has historically seen active management outperform market benchmarks.
Undoubtedly, passively managed ETFs can have a place in a diverse portfolio. The sheer breadth of the global ETF market means time-poor investors can use ETFs to add whole sectors to their asset mix, or follow particular themes such as sustainability.
But as we shift gears into a higher rate, higher inflation world, I believe an active approach is worth thinking about.
Active investing brings other pluses beyond the potential for above-market returns. The ability to select our own investments can mean we are more engaged with our portfolio.
It also brings the flexibility to move to a defensive position such as shifting funds into cash during market downturns to prevent significant losses. And an active approach gives investors pinpoint control over which companies, industries and markets they invest in.
Finding what works for you
Importantly, investing doesn’t have to involve an ‘all or nothing’ approach. Investors may choose to mix and match their portfolio, blending actively selected stocks with a variety of passively managed ETFs.
It’s about finding what works for you. But with the backing of good research, data and discipline, an active approach has the potential to outperform over the next few years, when market conditions may look distinctly different from those of the past decade.