by Rensburg Sheppards Investment Management
In constructing portfolios the task for investors is to balance their need for return with the degree of risk they are prepared to accept. Part of this task therefore is to calibrate the potential economic environment that lies ahead, part is to assess the probability with which each of those possible outcomes might occur and part is to judge how much of the potential return for each asset class is already built in to prevailing market levels.
Investors appear to have reduced the probability of a double-dip outcome (as they have gained reassurance from Central Banks that such an outcome is their intention to avoid). Testament to this change of sentiment is in the way markets reacted to the Irish crisis compared to a not dissimilar event concerning Greece back in the spring. Although peripheral bond markets movements were comparable (a widening of credit spreads versus Germany of similar magnitude to that in April/May), the reaction in equity markets was very different: previously equity markets had undergone quite a severe correction, with many major indices declining by 15% or more. On this occasion equity markets wobbled for a few days, but relatively quickly resumed their upward march. This reaction applied in general to “risk assets”, so included corporate and high yield bonds, commodities and private equity as well as mainstream stock markets.
Mr Bernanke has, in his policy of QE2, been christened “Helicopter Ben” by markets, referring to the fanciful notion that the easiest way to reflate the American economy would be to fly over New York in a helicopter scattering cash from the air. At times in the past year he must have felt as though he was flying through a dense fog, so that he had no idea whether he was over land or sea and the cash being scattered could be wasted for all he knew.
Although there are clearer signs of growth ahead than there were a year ago, and there are good chances that this growth is more broadly based rather than being fuelled principally by emerging markets, there are still clouds through which the authorities must navigate. The two principal concerns will be the health of the banking system and the possible inflationary pressures building up, principally within emerging economies.
While bank balance sheets have been strengthened and some Government injections of capital have been reallocated to the private sector at a profit for taxpayers (such as the stake in Citigroup), much remains to be done. Indeed the timing of the Basel III proposals for stronger capital ratios (which could be implemented by either further capital raising or by shrinking bank lending relative to balance sheets) has been deliberately phased in over the next seven to nine years in order to avoid any short term market pressures.
The inflationary fears are for the present concentrated mainly in emerging markets, with some evidence of them also in the UK, as we continue to have a higher level of core inflation than any other Western economy despite similar economic environments. Most of the advanced economies still have considerable surplus capacity, so it would be surprising if there was much ability to pass on fully any cost pressures emanating from raw materials. Some of this will have to be absorbed within the burgeoning corporate profits rather than added to customers’ bills.
This is much less the case in emerging markets however and this is where policy risk is probably at its highest currently. If the cash injected by Central Banks merely finds its way into emerging markets, then firstly Western growth will undershoot current forecasts and secondly the overheating there will become a much larger problem, leading to substantial corrective action. Finally there is the prospect of turbulence in currency markets, as investors decide that they can obtain appreciation from emerging regions and the Governments of advanced economies adopt a policy of competitive devaluation, which can only add to inflationary concerns.
Although the probability of a double-dip occurring has receded, the impact of it on risk assets would be substantial given the higher levels to which more optimistic investors have pushed them. That is why there is still merit in some aspect of “insurance” within a balanced portfolio. This is magnified by the increasing politicisation attached to economic decisions by the authorities, such as in China over the dollar exchange rate and in Europe over the Stability Mechanism. Policy error in these areas is much higher than if there are purely economic judgments to be made.
Although we do not as a central case expect to make any money from Government bonds, even at the slightly lower prices now prevailing compared to two months ago, the asymmetric nature of the risks in the system means this is a price worth paying for investors who have only a modest tolerance to risk in their portfolios.
For more information on Rensburg Sheppards Investment Management Service’s please contact either James Bedingfield or Owen Wright on 0114 2755100 or James.Bedingfield@rsim.co.uk