The uncertainty and volatility of the past few months has been unsettling. While it can be tempting to make changes to your investments during times like these, concern and anxiety are not a good mindset for making decisions that can impact you over the long term. The key to investment success is not to try and predict the future. It is about sticking to the solid financial plan that you built with your advisor. It’s what you do – or rather what you don’t do - during these volatile times that can make all the difference.
Recent volatility has led to more frequent changes to our asset mix
So far in 2022, markets have had to work through a wide range of developments, including:
- the war in Ukraine
- the possibility of slower growth
- high inflation, which is persisting for longer than expected
- the resulting impact of high inflation on monetary policy
- rising odds of a recession
These developments have led to a meaningful increase in volatility so far this year. In fact, intraday volatility of U.S. stocks is at one of its highest levels in history, behind only the global financial crisis of 2008/2009 and the Tech Wreck in 2002 (Exhibit 1). Bond market volatility has also picked up as a significant rise in bond yields has led to poor returns (Exhibit 2).
Exhibit 1: U.S. equity market volatility
As of March 21, 2022. Source: RBC GAM, Bloomberg. S&P 500 daily intraday range (Difference between index high and low)
Exhibit 2: U.S. Treasury bond market volatility
As of March 31, 2022. Treasury rate volatility represented by ICE BofA MOVE Index.
While the current environment is unsettling for many, the heightened market volatility and significant repricing in assets has allowed us to make more tactical changes to our asset mix than usual. We narrowed the degree of our underweight to fixed income on a number of occasions, sourcing the funds from both equities and cash, recognizing that the recent rise in yields has reduced the near-term valuation risk. This may provide a better cushion to portfolios against a downturn in the economy. However, we continue to maintain a slight underweight allocation to fixed income given our longer-term view that rates could continue to rise. We have also been active in our equity position. While we have been de-risking the portfolios for the last year, we did add some weight to equities as stocks sold off in the early days of Russia’s invasion of Ukraine. However, we later trimmed that position as the situation evolved and it became clear that the impact would be greater and last for longer than initially expected.
More recently, we further reduced our equity allocation, placing the proceeds into bonds and moving us closer to our neutral allocation. We continue to expect stocks to outperform bonds over our one-year forecast horizon and are maintaining a modest overweight allocation to equities. We recognize that the premium that investors expect to receive for holding stocks versus bonds has narrowed.
Looking forward, we expect the period of heightened volatility to persist over the near term. An active approach to asset allocation and portfolio management will continue to be key given the variety of risks that are currently present.
Rising rates can be good for portfolios over time
Against the current backdrop, central banks have begun to raise interest rates to combat inflation and are doing so at a faster pace than originally anticipated. This marks a clear transition away from the era of extraordinary monetary accommodation toward a period of quantitative tightening. This has resulted in a repricing of assets and will likely present a headwind to the economy and asset prices going forward.
Fixed-income yields have risen dramatically over the last few months and that has led to negative returns for bond investors. The U.S. 10-year yield recently reached its highest level in three years at 3.1%. Additionally, the significant and rapid climb in yields since December has led to high single-digit losses for bond investors, the largest decline since the early 1980s. This has some investors questioning their investments in bonds, especially those who are more conservative in nature.
Despite the near-term results, it is important to remember that rising rates can be good for bonds over longer time periods. Here are some important considerations for bonds associated with an increase in interest rates:
| 1. A rise in interest rates presents opportunities to purchase new bonds at higher yields, meaning more interest income. |
| 2. The total return for a bond includes both price and interest income. While it is true that rising yields can put pressure on bond prices in the short term, they also set the stage for higher interest income and thus better total returns in the future. |
| 3. As a result, the portfolio earns more income than it would have if interest rates had remained lower (Exhibit 3). So what may cause anxiety in the near term, could very well be a good thing over the longer term. |
Exhibit 3: Portfolios can benefit from rising rates over time as the portfolio is reinvested
Source: RBC GAM. For illustrative purposes only. *5 year annualized return for all three portfolios.
Scenario 1: Yields remain unchanged (dark blue).
Scenario 2: Yields fall by 100 bps across the curve during Year 1 (yellow).
Scenario 3: Yields rise by 100 bps across the curve during Year 1 (light blue).
Looking ahead, our models now suggest that further sustained upside pressure on yields may be limited. We are now expecting positive returns from government bonds over the coming year. We also believe that the higher level of yields could help to cushion returns for a balanced portfolio should we experience additional downward pressure in equity markets. This represents a meaningful shift in our view as we have been forecasting negative returns for bonds for several quarters.
Overall, it is important not to lose sight of the benefits of holding bonds in a multi-asset portfolio – they are an important source of income, stability, diversification and liquidity.
Stick to a diversified approach
The first few months of 2022 have been tough for investors. We expect volatility to persist in the near term given the variety of risks that are currently present and the wide range of potential outcomes given the ongoing conflict in Ukraine, surging commodity prices and a meaningful tightening in financial conditions.
While we think that the bond market has mostly adjusted to these risks, there may still be some downside risk for equity markets given the heightened risk of recession. Our own forecasts look for economic growth to continue to slow and for inflation to remain high for longer than we initially expected. However, we expect that price pressures will peak at some point this year and will eventually move lower, but remain above normal for the medium term.
In times like these, it’s important to stay the course and not deviate from your long-term investment plan. A well-diversified investment plan is built to withstand all types of market environments. Despite the extreme moves that we have seen in both the bond and stock markets, a diversified strategy has helped keep volatility in check, mostly keeping daily returns in a range of +/-1% (Exhibit 4).
Exhibit 4: RBC Select Balanced Portfolio daily returns
Performance for RBC Select Balanced Portfolio, Series A. As of March 21, 2022. Source: RBC GAM, Bloomberg
Reducing the magnitude of day-to-day volatility, especially on the downside, is key to keeping investors focused on their longer-term goals. That is sometimes easier said than done.
In a recent article, I shared that it’s what you do – or rather what you don’t do - during these volatile times that can make all the difference in the long run. In addition, it’s important to focus on what you can control. This includes keeping your emotions in check, staying invested and focusing on your financial goals – all of which can keep you feel more confident in the current environment.