Investing money at its most basic is just delayed consumption. Putting $250 away versus buying another pair of shoes simply means you can buy those shoes at some point in the future. It makes sense then that the baseline goal of investing is to protect the purchasing power of your money. The good news is that by paying basic attention to asset allocation, tax rules, costs and generally not overmanaging, the goal of staying ahead of inflation is achievable!
2023 won’t be perfect. There is always something happening the world and news travels so quickly that short term volatility is here to stay. The best quote to remember is that in the short term the markets are a voting mechanism and in the long term a valuation mechanism. But 2023 is fundamentally a shift to a better base for investors which is good, because the challenge to stay ahead of inflation just got harder. For 2023, here are the two macro themes that must be considered.
Interest rates are normalizing
Everything has a cost, and for money that is the interest rate. Focusing only on the negative implications of rising rates misses the point. Rates had to rise. They were artificially low for too long distorting everywhere the cost of money was a factor. Buying a house, the pricing of stocks and bonds, even the composition of corporate balance sheets. Since 1982 interest rates have been trending down providing a huge tailwind for investors. And the last decade has been historically unprecedented! The emergency rates since the Great Financial Crisis bookended by the pandemic made money essentially free. It is obvious in hindsight, but the “too low for too long” interest rates gave us the “everything is expensive” market. Now that is unwinding and that is a good thing for investors, so let’s consider the two implications.
Accept some pain in your core portfolio. Pain in satellite allocations like crypto, thematic ETFs and some tech stocks are staggering but that is a small allocation for most. Nope, we are talking about most investors with a typical mix of bonds, REITs, infrastructure and stocks in their RRSPs. There is going to be losses in areas we have not seen before, like our investment grade bonds holdings. Accept it and that allocations over the last few years were probably made at an inflated price. If the rationale for holding your investments is still intact, keep them and add to them. It is likely too late to sell anyway.
Look at your current portfolio as a better representation of the value of your holdings. In less than a year, interest rates have risen 4% and are still trending up. Whether the central banks have gotten this right is a hard to know until it’s over and the expected volatility in capital markets will be the daily vote on the matter. But from a valuation perspective, rates are now back to roughly 2008 levels before the historically low rates kicked in. Now valuations in your holdings are more realistic, and a better base to build on.
Living is going to cost more
The official Canadian CPI rate will be released mid-January, but most of us can see it when we fill-up our car, buys groceries and pay utility bills. Prices are going up. How far, how fast is anyone’s guess. But if interest rates are experiencing a “reversion to the mean” moment it seems reasonable to expect the same of the cost of living. There will be a plateau at some point, but we are not likely going back. There is a lot written about the underlying reasons, from aging populations to onshoring critical manufacturing like chips and medical supplies. But one theme is easy to see and understand and that is de-carbonization in daily life. Everyone has reached the tipping point and wants change, and that will mean a move away from cheap energy. This is structural long-term change that will filter through the input prices of most everything. If our investing goal is to maintain the purchasing power of our money, then it just got harder.
It’s time to review your hurdle rate. Your hurdle rate is what an investment’s long term (5 years+) return potential must beat to be worth it. Investing is delayed consumption, so the opportunity cost of an investment is what you could do with the money today. If you are a mortgage holder, simply look at your interest rate as a hurdle rate since pre-paying a mortgage is risk-free return. In 2023 a lot of fixed rate mortgages are going to be about 5-6%, paid in after tax income. So, in pre-tax income, you are looking at a hurdle rate of approximately 7% which is conveniently where inflation sits. What does this mean to investors? A hurdle rate of 8% seems reasonable, and you should look at the 5- or 10-year trailing return rates of each of your investments to see where they stack-up. Everyone’s situation is different, so if you are holding investments significantly below your hurdle rate at least be educated about that and understand why you are holding that investment. Investing was not meant to be easy, in 2023 most investors will have to revisit asset allocations now that money has a normalized cost.
Work through 2023
2023 is a transition year as the higher cost of money and thus lower liquidity work through capital markets. There is a manufactured slowdown already here or coming. Whether it is a recession or not is merely a technical matter that will only be known after it is over. Markets will be volatile and overshoot at times, up and down. The takeaway is that the reversion to the mean interest rate hikes is painful in the short term and healthy in the long term. This is a structural shift and we are not likely going back nor is the cost of living. Review asset allocations, keep the good stuff even if it’s down, re-visit your hurdle rate and ensure that the average potential return rate of your total portfolio is at least above inflation. Good investing!