As I write this, we are witnessing the horrors of war in Europe, something my generation thought would never happen again. The loss of human lives and the impact of displacement of millions of people are incalculable.
The effects of the crisis are felt worldwide and investors need to consider what it means for them. From my conversations with clients, the number one concern at the start of the year was inflation, and the recent tragic events have amplified this, with a dramatic increase in energy prices.
In this environment, the first instinct of investors is to take money out of the markets. Indeed, the client activity we are seeing since the start of the year suggests this narrative is winning to some degree.
However, in times like these, it is important to not lose sight of the long-term investing principles learned from decades of financial history.
One of the primary lessons is that if you are really worried about inflation, the worst thing a long-term investor can do is to sell out of equities or private assets as these are the primary assets that are likely to protect against inflation in the coming decade.
How do we then position ourselves? The first step is to have a plan. For most affluent or emerging affluent investors, the number one goal of an investment plan – after taking out insurance policies to help provide financial coverage in the event of death or health issues – is to prepare for retirement. The challenges with this process are huge.
Generally, in life, the longer you are trying to predict the future, the less confidence you have in those predictions. Let’s take an example. Let’s say you are around 30 years old; the decisions you will probably have to make during your lifetime will include earning a living, accommodation, marriage, saving for kids’ education, and retirement planning. The complexity of decisions is too often enough to get people to give up, or at least hugely delay, planning at all.
If that is not enough to worry about, inflation is also something you have to take into account, especially when it comes to such long-term horizons. While inflation has become more topical in the past 12 months —
as gains in annual consumer prices soared to the highest level since the movie E.T. was released 40 years ago — the truth is the impact of inflation is generally under-estimated because you cannot see it on a day-to-day basis.
At 30 years old, you are probably looking to retire in approximately 30 years and hopefully live for around 20-30 years thereafter. Now, nobody knows what will happen to inflation over the next 30-60 years. But let’s take history as a guide.
In Asia, inflation has eroded the value of 100 units of local currency markedly over the course of the 30 years (from 1989-to 2019), just prior to the onset of the pandemic.
The ‘best’ performers here are Taiwan and Singapore, where the currency’s value – or purchasing power in economists’ parlance – has ‘only’ fallen 38% and 39%, respectively. At the other end of the scale, you have Vietnam, Indonesia, and India, where currencies have lost around 90% of their local purchasing power over the same period.
Against this backdrop, most financial asset classes, with the exception of cash and deposits, have delivered returns that have retained purchasing power.
Global equities and private equity have led the way, delivering an annualized return of 8.5% and 13.6%, respectively, in the 10 years to September 2020, handsomely beating inflation.
Bonds have also done well since the early 1980s as central banks declared war on inflation and structural disinflationary pressures kept the downtrend on interest rates and bond yields intact.
Of course, history can be misleading when we are more concerned with the future. We believe it is getting harder and harder for bands to generate strong returns going forward and outpace inflation.
Lower starting yields mean that bonds will likely lose purchasing power for investors, even assuming inflation normalizes back towards 2%. Even higher-yielding, or sub-investment grade, bonds are expected to return just over 2% per annum over the next 7 years. Therefore, we believe investors will need to have an alternative plan when it comes to keeping up with, let alone beating, inflation.
We have some good news. First, we expect equities and private assets to continue to provide a good hedge against inflation in the coming years. This is shown in the table below, which is a key input into our robust asset allocation process, wherein we take into account capital market assumptions over longer time horizons.
Second, in financial markets, the longer your time horizon, the greater the confidence you can have in the expected outcome – while you will get a wide range of forecasts for returns over the next 12 months, longer-term returns expectations are usually relatively similar.
Finally, long-term expected returns have generally proven to be reasonably accurate and therefore can be used as a decent yardstick when it comes to planning ahead.
The second and third factors are often not widely known, which is probably why most people find it so challenging to plan for the longer term and instead commit to investments for the short term. Source: Financeyahoo