It is not always easy to know which way the economic winds are blowing. Some economists are talking of a double-dip recession in the US; some are referring to accelerated growth. Investors are confused and the result has been price volatility in equity and bond markets.
US economic data certainly hasn’t been encouraging. The US housing market is struggling and the job market has been anaemic at best, restraining consumer spending. But strong corporate profits, rising manufacturing production and record-setting US GDP per worker suggest that growth is possible and consumer spending will follow.
The most likely scenario is a middle-of-the-road, muddle-through scenario in which recession is avoided but growth remains muted.
Even if a double dip recession is avoided, high consumer and government debt will have to be worked off over the next decade or so — which will be done primarily through higher taxes from governments and higher savings from consumers.
So where does this leave the investor?
Investment markets have already priced in the possibility of recession and deflation. Bonds offer very low yields while shares offer very attractive yields, especially if one believes forecast earnings. In a ”muddle-through” scenario, earnings are unlikely to be as high as current forecasts predict, but this has already been large discounted in share prices. In contrast, the bond market has already priced in little or no inflation and even in a mildly inflationary environment, the 2,7% yield offered on US 10-year treasuries offers no protection.
It would seem, then, that the investor can do worse than to have a diversified portfolio of equities, with a mix of good quality growth and defensive shares, together with a reasonable cash holding. This should offer sufficient protection though one should avoid government debt, despite the possibility of further gains.
If growth and inflation surprise on the upside, a conservative portfolio of shares, property and cash will benefit while bond investors will sustain heavy losses as yields rise and bond prices fall.
While I believe that the balance of probabilities favour a growth scenario, the risk of recession and deflation is not negligible. As long-term investors, the prudent course is to construct a portfolio that favours growth but nevertheless offers protection in the event of recession.
Dane Schrauwen is Portfolio Manager, Equities at Foord Asset Management.
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