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We are still afraid of fluctuations
Any airplane pilot would tell you that turbulence is nothing to worry about. As unpleasant as it may be, the aircraft is designed in such a way that the risk of turbulence damaging the aircraft is very low. The situation is similar with the financial markets. The consequences of falling markets are understandably worrying, but it is important to wait and see: long-term global history shows that markets correct and continue to generate returns.
That’s exactly what we saw this year: global stock markets beat most analysts’ initial forecasts by almost 20 percent. Riskier pension funds have also achieved double-digit returns since the beginning of the year. The yields on the lowest-risk government bonds are also high this year at around 4 percent, while the yields on riskier bonds have increased by as much as 10 percent. and more.
Diversification pays off in the long term
While investors often emphasize the benefits of diversification, this year saw a rather unusual phenomenon: markets were dominated by companies in a particular sector for most of the year. Perhaps the biggest contributor to the stock market recovery has been the boom in artificial intelligence, particularly from technology and AI-related companies.
This is also shown by the results of the stock index: most of its growth this year was determined by only seven companies, whose share value increased by around 100 percent, and the influence on the general stock indices due to the large capitalization of these companies is extremely high. For example, the S&P 500 is up 21 percent this year, but each company in the S&P 500 is only up about 7 percent.
On the other hand, due to this dominance, a number of other sectors remained undervalued but have better prospects than this year, particularly those sectors where operating companies are more indebted and therefore dependent on market interest rates.
With bond yields rising, it makes sense to combine bonds and stocks at half or 60/40 ratio to diversify the investment portfolio, which was not the case in 2022.
Softer central bank decisions are not necessarily due to controlled inflation
For both investors and residents with real estate loans, the year 2023 will long be remembered as a year of restrictive monetary policy by central banks. The US Federal Reserve (FED) has raised interest rates eleven times in the last two years to up to 5.5 percent and the European Central Bank (ECB) ten times to up to 4 percent. At the end of the year, however, the tone of the central banks became somewhat milder – after we managed to break the wings of inflation, there were the first pauses in interest rate increases.
Inflation, which fell to a comfortable level and reached less than 3% in Lithuania at the end of the year, contributed greatly to the recovery of world stock markets. Investors are convinced that the Fed and ECB will not only stop raising interest rates next year, but will actually cut them.
What is particularly important, however, is whether the interest rate is reduced due to controlled inflation or due to the need to save the economy. So far, the economic data does not give much cause for concern, but the impact of high interest rates will appear a little late, so there is a risk that the economic situation will weaken, for example in the second half of 2024, although central banks will already do so lower interest rates.
Maintaining a balance of stocks and bonds in an investment portfolio should help provide a better risk-return ratio than any individual asset class. If the economy cools faster than expected today, central banks will be forced to cut interest rates more quickly, driving up safe-haven bond prices and cushioning losses in stock markets. However, if the global economy grows faster than expected, we will have a good year in the stock markets, but bond investments will also return 4-5%. and will not represent a major disruption to the overall portfolio.
Although a year seems like a long period of time in a person’s life, a single year is usually not that important in financial markets, where investments follow a decades-long strategy. Therefore, predicting the trends of 2024 or assessing the significance of 2023 for investors is not an easy task. In short, this year was full of interesting phenomena in the financial markets, but we will not be able to quickly determine what influence they had, how much they determined the trends of the next decade and how much they represented the exception to the rule.
#Paul #Kabelis #lessons #financial #markets