Analysts are predicting turmoil, fund managers arestocking up on gold. David C Stevenson is more sanguine but it still makes sense to plan for the worst.
By nature I'm fairly bullish. Despite our collective anguish over rising inequality, low-trend growth, squeezed 'real' incomes and decades-long deleveraging cycles, I reckon we're not in that bad a place, all things considered. But even inveterate optimists need to plan for the worst. And I think that we're now at an interesting crossroads.
My core view is that America and the UK are doing well, the eurozone is slowly picking up, and global growth has just received a tax-free boost courtesy of falling oil prices. But there are also some warning signs I can't ignore. CrossBorder Capital, a research house that focuses on global liquidity as a way of telling what might happen next to markets, is concerned.
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On its measures, liquidity in both the US and UK is tightening. That's partly due to central banks trimming quantitative easing (QE), but also because big companies are finding it harder to generate cash. This could show that the recovery is running out of steam, and that equities have run ahead of themselves.
Something wicked this way comes?
Equally worrying is a recent analysis from McKinsey that revealed that global deleveraging has stopped at a corporate level, and is going into reverse. In other words, businesses are piling on debt again. Hedge fund manager Crispin Odey has also warned that something wicked this way comes. He reportedly said recently that "this down cycle is likely to be remembered in a hundred years [it] will cause a great deal of damage, precisely because it will happen despite the efforts of central banks to thwart it... It is too early to see what will happen a change of this magnitude means the darkness and mist is very great."
Yikes! My own sense is that Odey and CrossBorder Capital are right about the global economy slowing but this is hopefully a hiccup, to be followed by another pick up in speed as low oil prices boost consumption and Europe stabilises. Yet even if I like to look on the bright side, it is sensible to look at the gloomier outcomes and how to invest for them.
There are certainly plenty of tripwires. As well as Ukraine and the political stand-off between Greece and the European Union, there's the volatility that would be unleashed if the oil price slides below $40 a barrel (a near certainty in my book).
But my biggest worry concerns the perceived infallibility of central bankers. Maybe Odey is right and the global economy is faltering. That would force central bankers to swing back into action. CrossBorder Capital has suggested we could see QE rebooted in both America and the UK. But more QE may not achieve much, except to inflate more asset-price bubbles. Investors might then work out that far more drastic action is needed (such as debt forgiveness) to deleverage the global financial system.
At that point, panic would emerge as investors lose faith in central bankers and head for the exits. This is the worst-case scenario that the likes of Albert Edwards at Socit Gnrale were right all along to predict the 'Japanification' of the West, and that developed economies would fail to cope with their accumulated debt, and collapse into deflation.
Worst-case doomsday investment scenarios
If this is the result, a wall of money would flood into the most liquid asset available at short notice US Treasury Bills. This would push up bond prices and drive their yields even lower. The last time I looked, US ten-year yields were at 1.93%, but in recent months that has fallen below 1.5% and in a disaster, it could plunge below 1%. Buying at those yields might sound mad, but as John Maynard Keynes rightly noted, markets can stay irrational longer than you can stay solvent.
So a cautious investor might want to buy a Treasury-bond exchange-traded fund (ETF), such as iShares USD Treasury Bond 7-10 yrs (LSE: IBTM), which tracks an index of seven-to-ten-year Treasuries, and Lyxor's iBoxx $Treasuries 10 yrs (LSE: US10) which tracks ten-year-plus. Those looking for safety might also buy the very best investment-grade corporate debt maybe betting on the mountains of debt issued by McDonald's and Nestl.
What about gold? Gold might seem perfect for this gloomy scenario. The world's central bankers have debased their currencies to such a degree that the only currency with any true value is gold.
That said, the disaster scenario starts with a base assumption in favour of US bonds (which would strengthen the US dollar, which is not ideal for gold) and ends with fresh QE (which would boost lots of other assets' prices). So I'm not entirely sure that gold is as good as it sounds.
However, managers who I rate have quietly started building their gold positions, especially in riskier, leveraged gold miners. Asia-focused value investor Greg Fisher (who manages the well-respected Halley Asian Prosperity Fund) has started buying cheap local gold miners, such as Hong Kong's G-Resources (HK: 1051), partly because they're cheap and partly in expectation of market turbulence.
I also note that the gold price has held out above the crucial (from a technical analysis point of view) $1,130-an-ounce level, so now may be the time to add a small layer of protection by investing in gold directly via a vehicle such as Gold Bullion Securities (LSE: GBS), or indirectly through a closed-end fund with precious metals exposure.
An optimist's defensive plan
As for me, I'd rather roll with the market ups and downs than panic, even in the disaster scenario. Losses could be huge in the short term. But eventually patient capital will return to equities, with most investors choosing quality blue-chips with the balance-sheet strength to survive a meltdown. That would suggest buying funds such as Finsbury Growth & Income (LSE: FGT) as well as Personal Assets (LSE: PNL). Neil Woodford's soon-to-emerge investment trust focused on 'patient investing' might also be a novel bet (see box below).
The UK's quoted hedge funds, notably BH Global (LSE: BHGG), BH Macro (LSE: BHMG) and BlueCrest Allblue (LSE: BABS), might also get their day in the sun as markets sag. These listed vehicles feed money to the managers' master funds, which in turn allocate capital across various strategies including 'macro' (bets on the big picture) and 'trend following' (buying what goes up, shorting what goes down).
These guys should hopefully make money out of increased market volatility (BH certainly benefited from the Swiss central bank's recent decision to stop repressing the franc against the euro) and markets are likely to be hugely turbulent in any deflation scenario.
I'd also keep an eye out for volatility in the bond market, which should help the recently renamed DW Catalyst (LSE: DWCG). This is an offshoot of BH, which focuses on credit markets. This small fund has a great track record, but now trades at a discount to net asset value after an underwhelming start to the year.
Also consider hedging your equity portfolio directly. You could use an "Infinite Turbo" from Socit Gnrale. This listed product is similar to a spread bet, but without the risk of geared losses. You can buy one, then sit tight and wait for the market to move in your direction. There are costs that cut into your potential returns, but I'd keep an eye on a particular FTSE 100 short turbo with the ticker MF04 (see sglistedproducts.co.uk).
This has over nine times gearing to the FTSE 100 on the downside (so if the index falls by 5%, this could gain more than 40%). The downside is that if markets keep rising, MF04 kicks out and becomes worthless, so you lose 100%. The kick-out level comes if the FTSE 100 hits 7,383 (8% higher than today's level).
Star manager launches new fund for the patient
Neil Woodford is one of Britain's best-known fund managers. During his 26 years at Invesco Perpetual, from 1988 to 2014, the funds that he ran Invesco Perpetual Income and Invesco Perpetual High Income beat their indices over the long term and amassed more than £30bn in assets at their peak. However, his defensive style meant that his funds performed relatively poorly in the post-2009 bull market.
Last year he left Invesco to set up his own business, Woodford Investment Management. His first fund launch, Woodford Equity Income, was the UK's most successful in terms of money raised and had more than £4.7bn in assets at the end of January. Now he plans to launch an investment trust, Woodford Patient Capital, which will be floated on the London Stock Exchange in April.Woodford has said that initially the trust will be invested in income-producing shares.
However, over the next one to two years he plans to replace these holdings with investments in unquoted early-stage companies (some larger, listed dividend-paying companies will be retained to cover expenses andprovide cash flow).
Woodford says that such companies can deliver higher returns than ordinary equities but that they are poorly served by the investment industry, since few funds take the long-term view that's needed to get successful resultsfrom this part of the market. He believes that investors should expect 10% annual returns from plugging this funding gap.
Of course, Woodford's fund will not be the only investment trust employing such a strategy. However, he believes that his past experience will give him an edge when it comes to picking firms to invest in.
One of the big problems with the private-equity and venture-capital-related funds that invest in this area is that they tend to charge large fees. Woodford plans to break with this by only charging an annual performance charge based on the returns. Another problem is that they either tend to be too small to spread the risk effectively, or so large that they are forced to invest in almost anything.
To prevent this, Woodford has set himself a target of £200m. He expects that this will give him enough money to invest in a wide range of companies, while still enabling him to turn down weaker proposals.
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