The economic scenario as we begin 2022 has rarely been so opaque. Retail investors need to ask some tough questions for which there seem to be no clear-cut answers.
The new normality is that financial markets today are characterised by lack of clarity, unknown risks and no guarantees that any expert forecasts are more reliable than others.
In the past two years, central banks have flooded the global economies with vast amounts of money. This strategy has helped many economies to avoid deep depressions. Still, the collateral damage is fast-rising inflation that can quickly destroy personal wealth.
Central bankers no longer focus on the control of inflation in the way they used to up to some years ago. They even change their minds very quickly as a result of trying to calm nervous markets and, at the same time, act as effective watchdogs against spiralling inflation.
Today, many agree that inflation is not as “transitory” as central bankers believed just a few months ago. Neither will monetary policy resolve the problem of rising inflation that today has quite complex dynamics driving it.
For those with a less conservative risk appetite, equities are usually a better hedge against spiralling inflation than bonds. But this comes with many caveats. The prices of US and European equities may already be quite high.
If economic growth stagnates due to Omicron and delayed structural reforms, equity prices might take a knock. This risk becomes more threatening if central banks start raising interest rates and withdrawing COVID support schemes too early.
The local equity market remains too shallow and dominated by very few publicly-quoted enterprises to offer the comfort of a strategy built on diversification. The European and US equity markets may offer better diversification opportunities for small retail investors.
The local bond market presents even more challenges for local investors. Local banks’ credit risk appetite is much more conservative today than ever before. This has driven some high-risk enterprises to resort to issuing bonds that admittedly pay higher returns than bank deposits but that carry considerable risk for inexperienced investors.
The bulk of credit risk has shifted from the banking sector to the less tightly regulated capital and corporate debt markets in the last few years. This is not a good thing for retail investors who may find risk pricing difficult to understand.
The new normality is that financial markets today are characterised by lack of clarity, unknown risks and no guarantees that any expert forecasts are more reliable than others
The return on global investment-grade bonds that are not linked to an inflation index may turn negative if inflation continues to grow at a fast rate. Even if we are nowhere near the scenario of hyperinflation experienced in the 1970s, bond investors with low-risk tolerance may suffer a substantial knock in their savings pot.
Those interested in emerging markets need to ask even more challenging questions. Rising geopolitical tensions and supply-chain changing strategies could mean that investment in technology, education and property companies in China may suffer severe declines.
Many investors channel their money in financial markets through institutional asset managers and insurance companies. This may save these investors from worrying unduly about monitoring market trends in the belief that experts can do a better job. This is often a sound strategy. Still, there is a caveat.
Some asset managers try to beat the low returns that the debt and some equity markets have offered in recent years by diversifying a part of their collective investment schemes in riskier assets. In the last few years, private debt has attracted substantial interest from institutional investors. Still, the higher returns it could potentially pay come at a cost – less liquidity and volatility in pricing.
Investors have their own risk tolerance levels. Small retail investors need to take professional advice if they do not understand the implications of risks linked to specific financial instruments. Many may not tolerate even a marginal loss on their capital, even if the cost of sticking to a low-risk strategy is a meagre return.
Regulators and sellers of financial investment products have a duty of care to all investors, but more so for small retail investors. Such investors may not understand that earning a four per cent return on a non-investment-grade bond, when banks pay much less than that for a term deposit, comes with significant risk.
This duty of care equates to more than just including long legalistic narratives on the inherent risks linked to specific bond issues. In 2022, the caveat emptor principle – let the buyer beware – does not absolve regulators and debt issuers from effectively protecting small investors.