Advisor says it's vital to bring buzz phrases down to plain English when explaining the role of their financial plan
Nothing ever lasts forever – and advisors know that the period of record low interest rates is coming to an end. Critically, as we exit that environment – and central banks have already us on notice about tapering – the industry must be ready and equipped to not only adjust portfolios accordingly but also talk to clients about inflation, rates and what this means for their returns.
Robyn Thompson, president, Castlemark Wealth Management, told WP that somne of her clients have been asking about the prospect of runaway inflation and how it could affect their portfolio and their ability to meet retirement goals. They want to know whether their financial plan is still intact and if the inflation outlook could impact their purchasing power.
The words “transitory” and “taper tantrum” are getting bandied around, Thompson added, and it’s an advisor’s job to bring those terms down to plain English and explain to a client how their financial plan will carry them through.
She said: “Don’t abandon your plan when you need it the most and have an understanding with the client about what their portfolio was intended to do for them. And then essentially look at what's available and what's changing in the space that they are able to take advantage of in order to provide that income.
“As an advisor, it's our job to educate clients, and it's our job to let them know what's changing and give them some comfort in the decisions that they've made and get them where they need to go.”
Inflation is undoubtedly the hot topic of the day. The prices of everyday essentials from groceries to gas to lumber have edged up, some quite significantly. Canada’s main all-items inflation index jumped to an annual rate of 3.6% in April, from 3.4% in March. It’s even more pronounced in the U.S., where the all-items inflation index spiked to an annual rate of 5% in May.
Central bankers and analysts in both Canada and the U.S. have been quick to explain that these sudden price increases can be largely attributed to a combination of strong economic growth following 18 months of pandemic-forced lockdowns and a low starting base for calculating the 12-month change in the rate of inflation.
Central banks maintain this surge will be transitory and any tapering of monetary accommodation will hinge on whether economic growth continues at its red-hot pace, whether job creation continues to expand, and whether wage inflation starts to take hold as businesses scramble to meet demand and compete for employees in an ever-tightening labour market.
Whether inflation does prove to be transitory or the upward trend continues is the great unknown at this point. If the latter becomes reality, monetary tightening could happen a lot sooner than expected. However, Thompson tells clients to forget timing the market.
She said: “Investors will often try to predict market turns in an effort to get out at a market top and then buy back in at a bottom. This is next to impossible in a normal cyclical market, but it’s downright dangerous when trying to correlate inflationary trends with market movement.
“Right off the bat, we advise our clients to forget about trying to ‘time’ stock market shifts. This is virtually impossible to do with any degree of accuracy if you think the market is about to sell off in reaction to even a hint of hawkishness by the central banks.
“In order to do this, you have to try to sell at a market top and then get back in at the market bottom. Trouble is, no one knows when central banks might make a move, and so market turns are clear only in hindsight. And the danger is that you’ll miss both exit and re-entry points, losing a lot of your capital in the process.”
There are early-warning indicators, though, that can help investors gain insight into whether inflation is transitory or will develop into a persistent longer-term trend, including bond yields. Yields on 10-year Government of Canada bonds and 10-year U.S. Treasuries have risen notably over the past few months. The former rose to a recent 1.37% in mid-June, from 0.68% in January, while the latter climbed to 1.5% from 0.917% in early January.
Thompson explained that persistent inflation always moves bond yields higher in lockstep, as investors seek to offset erosion of purchasing power. Yields have been rising steadily since last August, and because bond yield and price are inversely correlated, bond prices have declined, putting something of a dent in fixed-income portfolios.
She explained: “When a tightening monetary policy does occur, the stock market is likely to throw a 'taper tantrum', declining or perhaps even correcting, as investors digest a new era of tapering quantitative easing (i.e., the phase-out of bond buying by the central banks) as a prelude to increasing policy rates from their current near-zero level.
“Higher rates mean increasing borrowing costs, and reduced earnings, the expectation of which has investors re-pricing shares downwards – at least temporarily.”
So what can advisors do to protect portfolios in this environment? Instead of wholesale changes, a more nuanced shift within an already diversified portfolio is recommended, tweaking your holdings away from companies and sectors that are likely to sink during an inflationary period and focus on sectors that are more likely to be winners, particularly equities that will benefit from economic growth.
Thompson has suggested to clients they stay away from shifting portfolio bias to purely “defensive” types of holdings. This means that instead of overweighting to areas like consumer staples, utilities, and technology, which are typically prescribed for low-rate environments, consider more cyclically-oriented sectors, like materials, industrials, and consumer discretionary.
Financial services traditionally also fare well in a rising-rate inflationary cycle, as banks borrow at the short end of the curve and lend at the long end, where rates rise much faster.
She added: “Depending on the client portfolio, risk tolerance, and life stage, we might also recommend going from a 60/40 bond-equity split to a 40/60 split. Fixed income takes a beating in a rising-rate environment as bond prices decline when rates increase. But don’t abandon fixed income entirely, as they supply diversification and income, particularly if held to maturity, and help to reduce overall portfolio volatility.”