2nd September 2013
The sudden change in economic wind is bringing some dilemmas for investors writes investment journalist Cherry Reynard. For some time, the main risk has been of deflation, of a permanent stagnation of economic growth, but now it appears that recovery is a real possibility with all the attendant risks of a rise in interest rates and inflation. What are the key considerations for investors in this new environment?
The UK and other developed economies appear to be building momentum. Estimates for UK economic growth are being revised higher: The CBI revised its estimates for 2013 growth in August from 1% to 1.2%. As the BBC reports: “It also increased its forecast growth for 2014, from 2% to 2.3% based on predicted increases in disposable income and in business and housing investment.” Recent estimates from the IMF have also been moved higher.
These revisions have come hot on the heels of improving retail sales – retail sales – the British Retail Consortium said that on a like-for-like basis, retail sales rose 2.2% compared with last year – improving exports and stronger manufacturing and services data.
For investors, this requires a change of mindset. Since the credit crisis, investors have driven money towards ‘defensive’ areas such as high quality bonds and shares, pushing up valuations and lowering yields. Investors have been happy to accept these slim pickings because of the security these assets provided. But if recovery is imminent, investors have to start thinking about different considerations – inflation and higher interest rates, for example.
An economic recovery increases the likelihood of inflation, which in turn increases the likelihood of higher interest rates. This type of climate is bad for most types of bonds, but particularly at the higher quality end and for longer-dated bonds. Global bond managers have been moving to shorter duration assets since March of this year as trade website Fundweb reported recently.
To some extent, this possibility of higher interest has already been reflected in bond markets, where yields have started to rise, but there is likely to be more weakness in bond markets as quantitative easing is withdrawn and interest rates finally rise.
Investors therefore need to ensure that that they are both sufficiently protected against inflation and not over-exposed to interest rate rises. Where investors still want fixed income exposure, for example, they may need to focus on strategic bond funds and absolute return bond funds, where managers have the flexibility to protect investors against higher rates.
Inflation protection is a trickier area. Equities as a whole offer inflation protection but they are not trading at compelling valuations. That said, Gary Potter, joint head of multi-manager at F&C Investments, says that he is still generally focused on risk assets, rather than being defensively positioned, and has been buying on the recent dips in equity markets, rather than taking profits.
Normally, the obvious solution would be to look at areas such as commodities, emerging markets or smaller companies. But in some cases these areas still look relatively unattractive. Commodities are exposed to a slowdown in Chinese growth and its movement away from infrastructure investment as a driver of economic growth.
Emerging markets also seem unattractive: As Max King, Strategist, Investec Asset Management, puts it: “Emerging market equities and bonds have had a dismal few months, along with sustained economic disappointment and a plethora of disturbing political developments. Investors are now at least querying the thesis that superior long-term growth – combined with improved governance – would lead to sustained outperformance by emerging market assets. At worst, they fear a repeat of the collapse in emerging market economies, currencies and investment markets of the late 1990s.”
However, King’s ultimate conclusion is that emerging markets are suffering a cyclical, not a secular, bear market and still look like a potentially strong area over the longer-term. Equally, the movement in developed market equity indices since the start of the year has shown overwhelmingly that it is better to travel than arrive. So investors waiting for an economic recovery in emerging markets before they invest may ultimately be disappointed. Tom Beckett, chief investment officer at Psigma Investment Management, is overweight emerging markets on that basis.
Emerging markets, along with areas such as smaller companies, may also benefit from the ‘rising tide’ effect of global economic recovery. More cyclical companies such as banks and industrials may have moved higher over the past year, but they remain at a discount to defensive areas and may be far greater beneficiaries of the new economic environment.
As the recovery gathers momentum, investors need to ensure that their portfolios contain sufficient inflation protection and are not over-exposed to rising interest rates. Improving global growth should also allow some previously unloved areas to thrive. Investors who are still positioned for a deflationary environment with a portfolio of defensives may need to reconsider.