Andrew Pyle
October 27, 2023
Financial Planning in a Land of Confusion
With the events of the past few weeks, to say nothing of the past few years, I’m sure the lyrics of Genesis’ famous 80s song are coming to mind. Geopolitical tensions are rising, global capital markets have become more volatile and no one seems to know whether we are heading into recession or coasting along a path of resilience. Depending on who you talk to, the elevation in bond yields is either punishing the economy or having no impact.
At the time of writing, the S&P500 had just lost 10% of its value from the intraday high back on July 27th and the TSX was down around 9.7% from its intraday peak in early February. A drop of 10% is referred to as a “correction” and this would be the first such move since last year, when we saw a series of 10% hits and worse. The bond market has also been under pressure, though the roughly 4% decline in the Canadian aggregate bond index this year is a lot better than the double-digit decline in 2022. Still, analysts have been remarking for weeks now that the 3-year drop in North American bonds is the longest in history.
Yet, beyond the immediate concerns that investors might have about their portfolios, the confusion in the markets is also translating into uncertainty as to the viability of financial plans created before these unsettled times. This is normal behaviour for households and it is no different than what we see among businesses. When the economic and financial outlook is ambiguous, companies will err on the side of caution. This is why we saw massive layoffs among tech firms this year and why capital expenditures have been contained. Households may put off large expenditures and make drastic decisions with respect to their portfolios.
Before any decisions are made, we need to go back to the financial plan and the investment strategy to see what, if any, changes are needed in light of developments in the economy and markets. In doing so, let’s remember that there are two main drivers to a plan – spending and investment returns. Significant variations in either one of these variables can push a plan well off the desired trajectory. The pandemic had the effect of curtailing expenditures and government initiatives boosted saving. Post-pandemic, we have seen spending increase and savings are being depleted. The expected spending that was inputted into a financial plan before the pandemic will most likely be different today – for better or worse.
Actually, household spending in Canada has returned to its long-term trend, as shown in the chart above. Despite the sharp decline at the start of the pandemic, spending has rebounded and are basically on the same trajectory that has been in place over the past 20 years. In other words, households may now be spending pretty close to what they had envisioned had they created a plan in 2019 or earlier. Incomes may also be different. We all know examples of individuals who decided to take early retirement when the pandemic hit and this was especially true in the health services industry. This could mean a dramatic difference in household inflows today versus what was expected. This is one of the reasons why we get clients to update their financial plans no less frequently than every three years. Spending or incomes may have shifted, or maybe they are right on track.
Let’s assume that the income and spending side of the plan hasn’t changed that much over the last few years. What about investment returns? More importantly, does the current climate significantly alter the expected annual average rate of return over the life of the financial plan? To answer this, we need to break it down into the two main asset classes in a portfolio, namely equities and fixed income. There have been periods in time when one or the other sector faced challenges that might have caused someone to reconsider their financial plan.
For example, when the 2000 tech bubble implosion caused the broad equity market to correct, it took seven years before the S&P500 returned to levels prior to the slide. Just in time for another major pullback to occur (the Great Financial Crisis, or GFC) and then another six years before we got back to that 2000 high. Even with dividends, the TSX delivered only an average annual total return of about xx% during this time. Should someone have lowered their return expectations in their plan? Perhaps, but if we look back over the past 20 years, the total return index for the TSX is still up around 325%, or 7.5% on an average annualized basis.
Still, a large percentage of investors don’t have all their assets in the stock market. To the extent that many Canadians on the glide path to retirement, or are already in retirement, have gradually adjusted their portfolios to include more fixed income, these past few years have also been stressful. With central bank policy rates rising to cool off inflation, bond yields have elevated to levels not seen since around the time of the GFC, which means bond prices have sunk.
Since the peak in 2020, the Canadian Aggregate Bond Total Return index has declined by around 15%, though it was down 17% at the low seen last October. This has been the largest pullback on record and caused many to cash in their bonds, in favour of cash-equivalent securities or short-term GICs – not only crystallizing losses, but limiting the portfolio’s ability to recover. If we take a longer-term view, the aggregate index is still up just under 100% over the past 20 years, even with this record slide. That works out to a 3.5% average annualized gain.
Let’s say that an individual has maintained a balanced strategy in their portfolio over these past 20 years and assume further that the only two securities in their portfolio was a Canadian bond index ETF and a basket that tracked the TSX. Before fees and taxes, this portfolio would have theoretically generated an average annual return of 5.5% and that is with the movements over the past few years. When constructing a financial plan today, we would plug in an average annual return before fees that is close to this. The question that comes up is whether this is reasonable considering all that is going on?
In terms of the equity component, it is hard to say. Most would still probably think of a 7% average total return on the TSX as doable over the next 20 years, keeping in mind that anywhere from a quarter to a half of this return would likely come from dividends. And we would not suggest all of the equity exposure to be in Canada to begin with, instead looking for better diversification and growth opportunities outside of our country. On the bond side, I would argue that there is higher confidence in generating a 3.5% average annualized return over the next 20 years given where yields are today. If we had looked at this situation, say three years ago (when the 10yr Canadian government yield was 0.5%), the confidence would have been lower.
In short, Canadians definitely should be reviewing their financial plan regularly and looking at both spending and investment return assumptions, but they should not be panicking about recent events having a substantial impact on where they will be years down the road.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. He and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.
Yields/rates are as of October 27, 2023 and are subject to availability and change without notification. Minimum investment amounts may apply.