Should investors go for growth or play it safe?

Growth

Xavier Denis

Chief economist-strategist, Société Générale Private Banking

Until 2007, global growth had been artificially boosted by excess leverage of households, financial institutions and governments.

The result is that debt levels spiked up, leading to a major crisis. While global growth is set to run at a lower pace in the coming decade than in the previous decade, it will continue to be sustained thanks to developing economies adopting market-friendly policies. The IMF forecast still predicts global GDP growth at around 4 per cent over the coming five years, a favourable backdrop to play investment growth strategies.

Since the onset of the great financial crisis, fear of depression has triggered a massive derating of risky assets. That was warranted until recently but systemic risk has significantly receded since the ECB stepped up its interventions, alleviating the eurozone debt crisis. In the US, while the recovery remains subpar, growth prospects are steadily improving. Over time, central bank policies will continue to be extremely accommodative as deflation remains a bigger risk for the West, providing support to risky assets thanks to strong liquidity.

During the past years, markets have been more driven by macroeconomic developments than by corporate indicators. The zero interest policies implemented in advanced economies allow a cheap refinancing for corporates, boosting their profits. Corporate balance sheets are evidently strong and big companies sit on large piles of cash, whereas corporate margins have reached historical new highs.

However, private investors have remained on the sidelines when considering investing in equities both in Europe and in the US. Even institutional investors have remained underweight equities compared to long-term preferred allocations. Looking at large caps, they tend to be more and more immune from regional economic shocks as their turnover and profits are increasingly spread over the globe. Current low valuations, well below their 20 year average in the US and Europe, mainly reflect risk aversion and that real money investors have been reluctant to return to equities.

Alternatively, ‘safe haven’ sovereign bonds offer negative real yield even at 10-year maturities. This indicates strong risk aversion but this has likely run its course, as yield curves are being kept artificially low and flat due to massive cash infusions and direct central bank sovereign bonds purchases.

Emerging market prospects look brighter than ever from a comparative point of view. Growth rebalancing will entail more attention by policymakers to domestic demand as a growth support over time. By 2020, the emerging market middle class will account for more than 50 per cent of world middle class consumption (two-thirds by 2030) according to the Brookings Institution. This is impressive catch-up, offering appealing market opportunities.

The financial crisis has overshadowed the massive progress made by frontier markets. Africa, for example, has been growing at a 5 per cent annual pace. This should eventually lead to significant portfolio reallocation towards emerging markets, especially Asia.

The commodities boom is also a positive driver for emerging economies. A large fraction of emerging markets are net exporters of commodities although some important economies, such as India, are net importers.

We should keep in mind that the coming decade should see a return of modern finance. Asset return rankings are expected to reflect risk-adjusted returns. This means equities should outperform credit and the latter should top sovereign bonds, which will yield higher than cash. The IT bubble and the Great Recession have strongly hammered equity performance. It is not something we should consider repeating this coming decade. So it is better playing growth when valuations are still low than waiting too long for a better entry point that may never show up.

Dirk Wiedmann, Rothschild

Protection

Dirk Wiedmann

Head of investments, Rothschild Wealth Management

The current investment environment is challenging. It requires considerable skill to generate positive real returns for clients without undue risk. Leading government bonds are extremely expensive and overvalued and, with banks also fragile, there is a need to completely rethink options for capital preservation. Simply holding cash is no longer an option.

The positive economic headlines and extremely generous funding from the ECB to eurozone banks that began in December 2011 have boosted sentiment this year. We’re conscious that ample liquidity caused by the monetary stimulus to prop up the financial system could add to the upward momentum, as it did in 2009 and 2010. Yet, while another downturn does not seem imminent, now is not the right time to be increasing exposure to risky assets.

Why is this? There are still many reasons to be concerned about the broader outlook, but the market appears to be ignoring a number of major risks. The first is the rising oil price which, if it spikes and stays high, could easily push the global economy back into recession.

The second is the eurozone. Policymakers have made little real progress in tackling the problems behind the crisis. Even if a best case scenario plays out, Greece will remain uncompetitive and its debt burden too great. The ECB’s generous funding may improve things in the short-term, but there is a clear risk of surging inflation when confidence returns.

These factors, combined with a sharper than anticipated slowdown in China, unsustainable sovereign debt levels and Japan close to a tipping point on its debt payments, mean markets are still fragile. To protect wealth, it is therefore necessary to adopt a cautious stance and a globally diversified asset allocation, with a bias towards real assets, Asia and emerging markets, ‘safe’ bonds and strong currencies.

Currently, our asset allocation is heavily weighted towards cash to aid short-term capital preservation. However, returns from cash over the medium-term are likely to be poor. Government bonds are expensive and offer no compensation against the surge in inflation we fear. Corporate bonds, particularly those of emerging markets denominated in local currencies, which should be boosted by better growth and public finances, are a better bet. We also rate AAA-rated government bonds issued by strong countries such as Sweden, Norway and Switzerland and favour strong currencies at a time when true safe havens are becoming much harder to find.

The longer-term outlook for equities is bright and current valuations would usually lead us to a neutral position. However, at the moment, our positioning is slightly underweight as we believe equities have rallied too far too fast and there will be some setback in the months ahead. Our exposure is truly global with a slight tilt towards Asian and other emerging markets, reflecting the fact that these regions offer the best growth opportunities for the foreseeable future.

The outlook for commodities is complex as higher oil prices may dent economic activity and, with it, demand for commodities. However, a higher oil price could prove inflationary, which may be positive for commodities. The investment case for gold is as strong as ever and we continue to hold large positions as a hedge against the turmoil threatened by negative real interest rates, central banks’ ballooning balance sheets and the weak financial environment.

The market is overlooking some of the clear challenges faced by the global recovery and it seems that a dangerous complacency has taken hold. We know that the risk of a permanent loss of capital matters to the majority of our clients at least as much as growing their wealth. With that in mind, a focus on ‘real’ diversification of risks and good security selection is key.