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Why pension losses after the horror year in global markets are likely to be worse than we think

Even before last week’s market fire, the scene looked ugly.

While it may have come as a shock to many, pension balance sheets – which exploded last year in the worst recession in more than a century – were already in the red late last month as the fiscal year drew to a close.

After the maelstrom of rising interest rates over the past week, the slide in global equity markets has turned that bleak prospect into a painful reality.

It’s best to mentally prepare now for a significant drop in your retirement savings when this June 30th statement hits your inbox.

Even those who played it safe — with a more conservative retirement option — are likely to see significant declines. Only those who, with foresight – or with a lot of luck – switch to cash at the beginning of the year will be spared.

Up until last week, it had somehow appeared that the global monetary authorities had managed to trigger a major downturn in financial markets without the usual accompaniment of panic and despair.

Australia’s ability to avoid Wall Street’s heavy losses appears to have ended.(AAP: Joel Carrett )

No longer. A mood of despondency has taken root in financial markets and, unlike previous downturns, there seems to be little room to hide. Everything has fallen lately. This has made life extremely difficult for investors, whether self-spun or professional.

And it will probably continue. After more than 30 years of falling interest rates and minimal inflation, the world seems poised to enter a new era – or perhaps an old one again – of sluggish growth, escalating costs and pricier capital.

It’s a world that many investors have never experienced before.

Australia has been an outlier on the global stage this year. While Wall Street has been down since January, higher commodity prices – courtesy of Vladimir Putin’s war on Ukraine – have kept financial market news off the front pages here.

Until now.

Why were we in the red before?

After Australians collectively bathed in the dishes of the global financial crisis, our major bond funds reviewed their investment strategies.

Most found they had far too much exposure to Australian stocks and that their portfolios were too closely tied to the local stock market.

As such, they actively diversified into offshore equities, real estate, infrastructure, bonds and other alternative investments to reduce the volatility of your fund’s performance.

The idea was that if one asset class bottoms out, it should be offset by others that are doing well.

Two hands holding a piggy bank full of coins.The resurgence of inflation has resulted in wages not having equal purchasing power.(Unsplash: Rawpixels)

But even after this rebalancing, a typical mutual fund would invest about 20 percent of your savings in the local market. Fortunately, this trend worked well through April as our stock market shrugged off global troubles.

However, most of the other assets performed pretty poorly and, unusually, all at once. The sudden resurgence of inflation — and central banks’ sharp hikes in interest rates to curb it — temporarily threw the theory of diversification aside. And now local stocks have joined the tumble.

International stocks, which make up around 30 percent of most bond portfolios, have been plummeting since Christmas.

If you’ve been stunned by our market’s sudden drop over the past week – which helped it plunge 15 percent from its April peak – consider this.

Wall Street is down 23 percent since January. The tech-heavy Nasdaq, which has fueled Wall Street’s stellar performance for more than a decade, is down 32 percent.

As for cryptocurrency, don’t even go there. At last glance, the entire market was in turmoil, with total losses now more than 70 percent off the top.

Bonds to be more Alan than James

This may come as a shock, but the driving force behind all investing isn’t the stock market.

They are bond markets.

Bonds are essentially promissory notes. Both governments and corporations issue them when they take out debt, usually with a promise of a fixed interest or coupon rate for a set period of time, say 10 years. Once issued, they trade in open markets that dwarf the stock markets.

A trader looks at financial information on IG Index computer screens on the trading floor in LondonU.S. bonds have fallen an unprecedented 12 percent over the past year.(Reuters: Simon Dawson)

Huge trillions of dollars are invested in them, and the sheer weight of that money makes them the foundation, the bedrock that dictates performance in everything from interest rates to real estate to stocks and currencies.

In fact, Bill Clinton’s adviser James Carville — the man who famously coined the phrase, “It’s the economy, fool” — is just as famous for this phrase: “I used to think that if there’s a reincarnation, I want to come back as President or Pope.” . But now I want to be the bond market because you can intimidate anyone.”

The past year has been really intimidating. For US government bonds, it was the worst year on record with losses of 12 percent. For comparison, the second worst year was 1984, when they lost 2.9 percent.

Because governments rarely default, bonds are considered risk-free. That’s why they attract so much money and so much attention.

Over the past 40 years, as interest rates have fallen, they have made huge gains. However, being risk-free doesn’t mean you can’t lose money on it, as many great professional fund managers have suddenly discovered.

There is an inverse relationship between interest rates and bond prices. When punters think interest rates will fall, they bid up bond prices. And that has been the one-way bet for more than 40 years.

But suddenly everything is turned upside down.

Once in half a century storm for US bonds

A chart showing the rise in US Treasuries from 1978 to 2020

So what does this have to do with you?

You have US bonds in your pension fund portfolio. With a mixed fund, about 10 percent of your savings are invested in so-called fixed-income investments.

Because they’re considered relatively safe — or at least were considered — they’re less likely to be included in riskier options like growth funds.

However, once you’ve settled on safer alternatives, like a stable or conservative option, about a quarter of your investment is in bonds…that have been shaken and stirred.

So where to now?

Ask five different economists and you’ll get 10 different answers. On the one hand …

However, it is difficult to see a rapid market recovery any time soon. The rapid rise in stock prices after the February 2020 crash came about because central banks, led by the US Federal Reserve, not only cut interest rates to zero, but also printed money like there was no tomorrow.

They had been doing this for a decade – ever since the global financial crisis wreaked havoc – and it hadn’t even looked like fueling inflation. During the pandemic, central banks — including our own RBA — jumped into the action.

Every time the Fed tried to withdraw some of that printed money over the past several years, stocks have plummeted and the Fed nervously backed down.

Now that inflation is on the rise, she has no choice. It will begin aggressively withdrawing that money back to relieve the economy.

And since the pandemic pump, it’s now up a staggering $9 trillion ($13 trillion). This will effectively amplify the impact of rate hikes.

Instead of buying up US Treasuries – as it did during the GFC and the pandemic – it will sell them, collect cash and drive up interest rates.

This will also cause bond prices to continue falling, which will continue to weigh on all asset markets and your retirement fund.

Until last week, when the US Federal Reserve pushed through a triple rate hike in one go, it seemed as if the pullback in financial and housing markets would be relatively orderly.

However, with another tripling expected over the next month — followed by doublings in September and November, and single prices in December, January, and March — neat isn’t the adjective that immediately springs to mind.

The only thing that could cause the Fed to retreat and cool off a bit is the prospect of a recession.

Which isn’t really a comforting scenario.

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