Steer clear of big bets in the current environment

In the face of rising global risks investors should ensure they are invested in the appropriate products and avoid taking on any big or concentrated market bets with diversification and risk management becoming even more crucial factors for any portfolio.

If we look at the current global environment there are serious risks stemming from four distinct areas, any one of which on its own could have serious repercussions in the global economy.

Although none is very likely to happen — and we do have policy options to cope with the fallout — these options are now more limited than usual, making the environment particularly fragile. As a result, markets are likely to remain volatile for the foreseeable future and risk management is paramount for investors.

These four risk areas are:

1. the eurozone debt crisis
2. the political dispute over the US budget and deficit ceiling
3. a possible sharp slowdown in Chinese economic growth
4. a Middle East crisis that leads to a sustained higher oil price.

If you look at the eurozone’s debt the crisis in Greece should not be a surprise, as in reality Greece has spent 50% of the time since 1829 either in default or rescheduling its debt.

A hard landing
Rather, the risk is the possible financial contagion into European banks and bigger countries like Italy should there be political gridlock and a credible deal not be reached. A messy default in Greece or other smaller countries could trigger a much wider eurozone crisis and this is a genuine risk that would have a global impact and could also affect South Africa.

In the US, meanwhile, the political brinkmanship over the budget and lack of agreement on raising the debt ceiling has sparked invtesor jitters and credit rating agency warnings.

Although there is a very low probability of no agreement being reached by the Republicans and Democrats, the risks are real due to the sheer size of the US debt problem: US debt is expected to escalate by some $11-trillion between 2008 and 2016, having only reached a total of $11-trillion in the 63 years between 1945 and 2008.

In China — after recording economic growth of 10.3% per year over the last 10 years — it is only normal for there to be a slowdown to a projected 8.2% per year over the next 10 years. This slowdown would be off of a higher base and in line with government policy.

However, risk comes in managing this transition, which is why fears of a “hard landing” have grown as the government has continued to tighten its monetary policy to combat inflation. The housing market and investment spending are particularly vulnerable to an “overshooting” in the slowdown.

The last risk is that of a much higher oil price, sparked by the further spread or exacerbation of political tensions in the Middle East from the Arab Spring movement. The oil price is already high on a historical basis, and should it move higher and remain elevated it could choke global growth. While I don’t expect this to happen, it is certainly a risk because it is impossible to forecast Middle East politics.

Diversification and risk management key
For investors, these global risks make the landscape a difficult one to navigate in terms of where to invest. Diversification by asset class, country and company is very important to minimise the risk of having large exposure to any one risk area. Investors should consult their financial advisers around risk management, to ensure their portfolios are structured appropriately.

It’s not about lowering your exposure to equities, because in reality many investors are already invested too conservatively — but rather managing the various macro economic and political risks within your portfolio. In fact, the high level of uncertainty is creating opportunity as asset classes are starting to offer better value.

Equities still the most attractive asset class for real long-term returns

It is important to remember that equity returns — both in South Africa and overseas — still offer the opportunity for solid real returns over the next five years. We are forecasting returns of 6.5% per annum above inflation from both the local and international equity markets through 2015, making equity the most attractive asset class by a substantial margin.

In South Africa we have increased future expected returns as the market has become cheaper over the last six months, falling from a forward price earnings ratio of 13 times to 11.7 times currently. There are now over 50 stocks on forward price earnings of less than 10 times (a good rough benchmark for value), but you still need to choose carefully. Although the JSE has been relatively flat so far this year, the second half of 2011 should produce better equity returns.”

Buy local bonds, but avoid foreign bonds
Looking at local bonds, we are forecasting a real return of 3.0% per annum over the next five years, which represents an attractive yield compared to cash returns expected at only 1.5% per annum. Offshore, cash and bonds are both still to be avoided due to very unattractive or negative expected real returns.

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