25 Nov 2011 | Capital Hill

Capital Hill on... investing for stagnation 

FEARS are mounting that Britain and other developed
nations could enter a sustained period of stagnation,
with little or no economic growth. This could severely
dent ‘risk’ assets – hitting people’s investment and
pension portfolios.

Trevor Greetham, asset allocation director at Fidelity, said: “There’s another slowdown under way: we’re seeing the start of a new credit crunch in Europe that could have severe consequences.

“Quite a lot of the policy ‘solutions’ will make the disease worse and there are signs that banks don’t trust each other; we’re starting to see a noticeable rise in bank lending spreads.
“Things are likely to get worse before they get better. Global growth indicators look pretty negative: growth is set to slow into 2012.”

Against this backdrop, how may investors position themselves? While the natural reaction might to be head for the exit and sit on cash, it is unlikely to prove the best solution. Capital Hill takes a look...
 

Beware pitfalls of cash

It might be tempting to liquidate and stick your cash in the bank, but remember that holding cash over the long-term is not risk-free: inflation erodes the real value of monetary assets.

Inflation dipped in October, but is yet to fall below the symbolically important 5% mark. The Consumer Prices Index (CPI) stood at 5%, down from 5.2% in September, while the Retail Prices Index (RPI), which includes the cost of servicing debt, was at 5.4%, against 5.6% a month earlier.

Peter Day, a partner at Killik & Co, the wealth planner, said: “Many Western governments, including our own, have been printing money at an alarming rate; this is likely to result in higher levels of inflation in the future.”

Little or no economic growth will mean that interest rates remain lower for longer. Markets are now forecasting an even longer wait for a rate rise, until Autumn 2014. That means returns on cash savings will also remain very low.

Patrick Connolly, head of communications at AWD Chase de Vere, the independent financial adviser, said: “While stagnation will help to reduce the effects of inflation, it’s entirely possible that cash returns still won’t match inflation, meaning that cash savers will lose money in real terms.”
 

Be flexible with bonds

Greetham is among the most defensive he has been for five years. He has recently taken a moderately overweight position in cash and is overweight government bonds in light of heightened levels of stock market volatility.

However, rocky stock markets have caused a flight to the best quality government bonds – pushing yields to record lows – so go for a fund where the manager has unconstrained flexibility to shift asset allocation between different bond classes in response to prevailing economic conditions.
 

Protect against inflation

Between 1970 and 1990 inflation eroded the purchasing power of £1 by 86%, making it effectively worth 14p. Whilst this is an extreme example, with RPI at 5.4%, the purchasing power of money will halve in a little over 13 years’ time.

Greetham believes inflation will drop towards or below the UK’s CPI target of 2% in the early part of next year as commodity prices come off, but others disagree. Adrian Lowcock, a senior adviser at Bestinvest, the independent broker, believes that inflation is likely to have peaked, but could remain above target for some time.

Day, at Killik, said: “Over the last two decades we’ve not had to worry overly about the effects of inflation as price rises have been kept under control, largely by cheaper imported goods from Asia.

“However, inflation has proven to be extremely sticky... [and] could continue to be a problem given the potential for further monetary stimulus and the developing world’s ongoing demand for various commodities.”

The capital amount will go up to reflect any overall increase in RPI between now and maturity. The bonds don’t have to be held until then: you can buy or sell them at any time during their life.
 

Focus on defensives

Within equities, experts favour defensive sectors over economically-sensitive areas.
“In this environment, it makes sense to structure equity investments toward defensive stocks, such as utilities, pharmaceuticals and consumer stables,” says Connolly.

“These provide products that people will still require in good times as well as bad: whatever happens we still need to use energy and eat food.”

Greetham at Fidelity favours US, German and UK markets, due to their better fundamentals, and healthcare and consumer stocks at the expense of cyclical areas, like materials and industrials.
 

Go for yield

Day urges investors to focus on financially-strong companies with dividends that are well covered by both earnings and free cash flow – many of which are also defensive in nature.
“Companies which are capable of generating sustainable income for shareholders will become increasingly sought after,” he said. “As a result, they could re-rate upwards, potentially providing the opportunity to make capital returns in addition to the dividend income stream.”
 

Look to pockets of growth

While Western world might experience stagnation, there is likely to be continued economic growth in developing countries, despite them nevertheless being impacted by the slowdown in the developed world.

The International Monetary Fund September forecast predicted global economic growth of 4%, with developed economies (including the US and Europe) in aggregate growing at 1.6% and emerging and developing economies growing at 6.4%.

“While economic growth doesn’t necessarily translate to stock market performance, it’s a good approach to try and benefit from the growth in emerging markets,” says Connolly.

“This can be done by investing in emerging market stocks or funds, but a better way might be to invest in Western companies which do a large amount of business in emerging markets. This approach may negate some of the risks of investing directly, such as variable standards of corporate governance.”

Scottish Mortgage, the Baillie Gifford-managed investment trust, invests globally, looking for strong businesses with above-average returns. In the five years to end-October 2011, it gave a net asset value per share total return of 34%. In share price terms, it was up 43%. Both were well ahead of the benchmark index, which returned 20%.

Chairman John Scott says: “While conditions in developed markets may continue to be tough and achieving growth overall here may be a struggle, many individual companies are likely to continue to do well.

“Powerful longer-term positive influences, notably the rapid growth of developing countries and the rapid pace of technological advance across many fields, remain in place.

“Painful market conditions may have to be endured for the remainder of the year, and possibly longer, but taking a deliberate long-term and unfashionably optimistic view provides succour.”
 

Be diversified

Nobody knows for sure what the economic future holds – or how this will impact on stock markets and other assets. In an environment of short economic cycles and sharp movements in prices, it becomes even more apparent how important it is to hold a diversified investment portfolio consisting of cash, equities, fixed interest and property.

This should provide the opportunity for growth in the good times and a reasonable level of protection in bad ones.

Frances Hudson, global thematic strategist at Standard Life Investments, said: “Investors should use scenarios and construct portfolios that are resilient to an array of different risks, but they are unlikely to be able to protect themselves completely.”

Scottish Mortgage Standardised Past Performance

30/09/06 - 30/09/07	30/09/07 - 30/09/08	30/09/08 - 30/09/09	30/09/09 - 30/09/10	30/09/10 - 30/09/11
34.0%	-28.1%	13.0%	30.2%	-1.0%

Source: Morningstar, share price mid to mid, total return 

The views expressed in this article are those of the author and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.

Investing in emerging markets is only suitable for those investors prepared to accept a higher level of risk. This is because difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.

Author: Jennifer Hill
Jennifer is an award-winning British financial journalist. She recently left The Sunday Times, where she was deputy Money editor, to set up her own company, mediahill Ltd. She is a previous personal finance correspondent of Reuters, the global news service, and personal finance editor of The Scotsman newspaper.

She has won or been shortlisted for six Headlinemoney awards, the ‘Oscars’ of personal finance journalism in the UK. She has also scooped or been nominated for accolades from the Association of Investment Companies, Ignis Asset Management, the Association of British Insurers and the British Insurance Brokers’ Association.