IT’S NOT YET TIME TO BUY THE DIP
This week's newsletter is a guest piece by Uyoyo Ogedegbe and Femi Fadahunsi.
If you are new to financial markets and have been playing on the shorter end (a few weeks or months), buying the dip must have worked unimaginably well for you these last few months.
Unfortunately, buying the dip as a quick way to make a profit is likely to stop working so well.
Why assets are likely to drop further
The US Federal Reserve (the equivalent of the Central Bank of Nigeria) has two key jobs:
To manage inflation (they work to keep inflation around 2%)
To keep unemployment rates low (around 3%)
As at March 2020, the most important US stock index had lost more than 35% of its value. Lenders were unwilling to lend money to companies and the risk of a systemic failure in the global financial markets was imminent.
To avoid a global financial disaster, the Fed began “injecting” money into the economy by buying billions of dollars worth of financial assets. It also cut the interest rate to zero.
This made the risk-free interest negative. In effect, if you bought a government bond since the pandemic began last year, you would have lost money to inflation. These policies forced people and institutions to invest in the economy instead of safe government bonds.
Since then, the job market has largely recovered from the COVID-19 slump (the unemployment rate is now < 4.5% from > 14.6% in April 2020), and the S&P price index has since grown by more than 100%.
At more than 6%, the inflation rate currently overshoots the government's target of 2% annual inflation by a lot. The Federal Reserve members have officially stopped regarding inflation as transitory (meaning, the higher prices won't remain so in the long term). To rein in the inflation, the Federal Reserve has begun tapering (that is, reducing the economic stimulus packages such as their mortgage-backed securities purchases). Tapering will cause a rise in interest rates across the world economy. You’ll soon see why this is important.
When the real risk-free rate (remember, it’s the real interest rate on the government bond after subtracting inflation) is high and attractive, investors prefer to invest in government bonds because they can make enough to beat inflation without taking on any risk. When the risk-free rate is negative, people don't have the option to avoid risk and earn inflation-beating interest on their capital so they can get into riskier investments with the hope of making inflation-beating profit. This is obvious in Nigeria—people are attracted to very risky assets, in part, because of the promise of high returns since money saved in the bank loses value quickly.
Given the current market conditions and high asset valuations, the Federal Reserve Chair’s announcement that they no longer see the high inflation as transitory, and that they have suspended purchasing assets to support the economy, makes investors more cautious of risk. If the Federal Reserve makes the interest on bonds attractive, a few things will happen:
Many investors will prefer to leave their capital in risk-free government bonds
Cost of borrowing will go higher across the broader economy since lenders would be able to beat inflation by holding government bonds, and borrowers would make their interest rates to private companies and individuals higher than the risk-free rate.
Much less capital would be available to buy into riskier asset classes.
Prices of riskier assets will drop substantially.
In summary, traditional investors who are currently invested in riskier assets (e.g. growth stocks and crypto) because of the negative risk-free rate, would move most of their capital away from risky assets and into government bonds if the risk-free interest rates become more attractive. In short, if governments make their interest rates attractive again, it will reduce the number of investors willing to take risks with their capital.
The increased probability of the risk-free rate going higher and the suspension of the Fed’s asset purchase programme implies that prices of speculative assets would drop further in the midterm as investors move their capital to government bonds and less volatile assets.
Our primary advice would be to reduce leverage (borrowing) on your investments and to buy dips on volatile assets with more caution.
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