Many of your clients probably are apprehensive about investing in today’s uncertain economic climate – and they have a right to be. There’s a great deal of risk out there – much of it political and, thus, impossible to predict.
Republicans and Democrats could send the U.S. economy plunging into recession if they don’t agree on major spending cuts in the next few months. Social unrest could erupt in Europe, either in the weaker southern countries, in which the populace refuses further austerity, or in the stronger northern countries, in which voters could deny further financial support to the south.
Most economic strategists and portfolio managers interviewed for Investment Executive‘s Outlook 2013 (see special pullout section) assume both the U.S. and Europe will muddle through because they believe that politicians will ultimately do what’s needed to prevent dire outcomes. But the possibilities for crises will continue to hang over financial markets.
And muddling through does not mean robust growth. The consensus forecast for U.S. economic growth in 2013 is 2%-2.5%, and only a tepid emergence from recession in Europe is expected in the second half of the year. Combined with continued weak growth in Japan but a pickup in the emerging markets, including China, that spells global growth of around 3.5% – only a little better than last year’s 3%.
In broad terms, portfolio managers favour U.S. and emerging market equities over European and Japanese stocks. But they don’t expect booming stock markets anywhere.
However, portfolio managers are not sold on fixed-income, which they tend to underweight vs equities, because interest rates are expected to remain low in the industrialized world. That means negative returns on government bonds and returns on corporate bonds that may not exceed the dividend yield on the stocks issued by the same companies.
This year’s Outlook 2013 report discusses the risks and opportunities across the investment horizon at home and abroad. Each type of investment, geographical area and industry sector has negatives, but there is relative safety and the opportunity to grow assets slowly if investments are chosen and monitored carefully.
Diversification is always the first step in minimizing risk. If the value of investments in certain asset classes, regions or sectors decline, there are always others that increase. Even if the worst happens and the world is plunged into a major recession and deflation, the value of equities and corporate bonds will decline, but the value of government bonds and gold will increase.
And if global economic growth is stronger than expected, the value of bonds will decline as interest rates rise. But the value of equities will increase, although at different rates (depending on the sector and/or region).
The second step in minimizing risk is rebalancing your clients’ portfolios -“The one guaranteed source of performance,” says Norman Raschkowan, executive vice president, investments, and chief North American investment strategist, Maxxum funds, at Mackenzie Financial Corp. in Toronto, “because it automatically introduces the discipline of buying low and selling high.”
The third step is finding equities that are likely to appreciate in a moderate-growth environment. There are always companies that do better than others in any given region or sector. That doesn’t matter as much when equities markets are booming, when even underperforming stocks are still rising. But it matters hugely when economic growth, and, thus, earnings growth, is sparse.
When companies can’t count on ever-increasing growth, they have to make intelligent decisions. They have to figure out where and when to expand, where and when to draw in their horns, and how to protect and enhance market share and profit margins.
@page_break@ This makes the current environment a stock-picking one. As the Outlook 2013 report shows, there are gems in places with little or no growth, such as Europe and Japan, and there are risks of paying too much in apparently good markets because some valuations are too high.
Here’s a look at what you and your clients need to consider as you build or adjust portfolios:
– bonds. “Government bonds [in these present circumstances] build risk into portfolios,” says David Andrews, director of investment management and research with Richardson GMP Ltd. in Toronto. “As economic growth and interest rates rise over the next 18 months, government bonds will be hurt the most.”
Andrews notes that clients need some fixed-income investments as a buffer against the risk of very slow growth or recession, but he strongly advises that these be of short duration so that clients won’t have to hold the bonds for more than a few years after rates start rising. He adds that investment-grade and high-yield bonds will be hurt as well, but offer a little more protection in the form of higher coupons.
One way to manage the duration risk in bonds is to buy bond-based mutual funds that have active portfolio managers. However, Sadiq Adatia, chief investment officer (CIO) with Sun Life Global Investments (Canada) Inc. in Toronto, warns that many advisors “may not have noticed how bond managers are lowering the quality of their portfolios.”
He suggests carefully monitoring what’s in the bond funds in which your clients are invested: “Bonds may seem cheap in Europe, but that’s rightfully so.”
– equities. Many portfolio managers prefer large-cap, dividend-paying stocks with strong franchises, as their dividend yields can match or even exceed the interest of the same issuing companies’ bonds. And the possibility of capital appreciation and higher dividends in the future also exists. Multinationals selling globally are particularly favoured.
It’s important that you ensure that the stocks your clients buy are not too expensive. Most advisors look at price/earnings (P/E) ratios – and P/E is useful. But Ross Healy, chairman of Strategic Analysis Corp. in Toronto, believes it’s important to look at price/book (P/B) ratios as well.
If you exclude goodwill and intangible assets from the book value, the P/B ratio will show you how the share price compares with the underlying value of the company – i.e., what it or its parts can be sold for. A P/B ratio below 1.0 is very cheap. If the ratio is higher than 2.5, you need a good reason to recommend the stock to clients.
Another important point is to make sure companies aren’t borrowing to pay for dividends, says Leo de Bever, CEO and CIO of Alberta Investment Management Corp. in Edmonton, because those dividends may not be sustainable.
He notes that Moody’s Investors Service Inc. in New York estimates that up to US$5.5 billion in dividends in the U.S. were financed by debt during the third quarter of 2012. Moody’s has downgraded its ratings on 27% of companies that issued bonds to pay dividends in that quarter.
Even more dangerous would be investing in products that use leveraging strategies to produce high yield, says Healy, who suspects we’ll start seeing more such products, given the current high demand for yield.
© 2013 Investment Executive. All rights reserved.