Wednesday, 17 June 2009

Opportunities still abound in tougher financial times

Opportunities still abound in tougher financial times

Published: 4:01PM GMT 19 Mar 2009

Managing client money in a downturn is proving to be the ultimate stress test. In an economic downturn, capital preservation becomes a greater consideration as investment risk increases.

Stockmarkets can experience sharp declines, volatility rises and traditional sources of income can be eroded. Such periods of economic difficulty also provide attractive opportunities. Being positioned with flexibility means it is possible to take advantage of these as they emerge.

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To manage client money successfully in a downturn we have to try to identify the environment in which we are operating. This has been made more difficult by the rapid change in the economic and financial landscape in recent months. But certain factors are apparent:

A number of leading banks have wiped out their capital. Governments have, however, made it clear that they will do everything possible to protect savers and keep the banking system functioning. This is good news, but investors need to be wary of any loss of nerve by the authorities as they face up to multiple bank recapitalisations.

We have entered a recession that will be deep and last for several years. There will be a sharp fall in the rate of inflation and we may even see a negative number this year. Interest rates will continue to fall.

Given the level of uncertainty, the value of capital and the extensive range of attractive opportunities available it makes no sense to lock up capital even if apparent returns are attractive. For example, investors in five-year structured notes backed by a bank whose credit rating is deteriorating, will attest to how uncomfortable they feel at present and how much poorer they are in the short term.

Equally, borrowing to invest even though interest rates are falling is unnecessary and potentially dangerous.

Backward-looking asset-allocation models have also failed to protect investors. Decade-long average returns and past correlations have been of little use over the past year and they will continue to provide poor guidance for a number of years to come.

Governments are fully occupied in an exercise that may best be described as battlefield triage of the financial system, while at the same time trying to work out how to sustain the rest of the economy and the confidence of consumers. They have now moved on to search for explanations as to what went wrong and who to blame.

On the other hand, investors should have a different agenda.

Liquidity in all asset classes is critical so that when the forced selling stops and the markets stabilise, investors will be able to use valuable capital to maximum effect. There are attractive opportunities in all asset classes.

Interest rates are low and probably heading lower. Returns on cash are correspondingly low, but having a good cushion of liquidity provides the flexibility to redeploy this quickly as opportunities open up. Gilt yields have tumbled, reflecting the decline in interest rates and the expectation that inflation will remain low for some time.

However, while this may hold true for now, the combination of substantial fiscal and monetary stimulus packages is likely to rekindle inflation in two years. This makes inflation-linked gilts look more attractive at present.

Corporate bonds have delivered a poor return over the past year as the default risk priced into them rises in step with the deterioration in the economic environment. However, there are a number of high-quality investment-grade bonds offering attractive yields well in excess of government stock.

Equity markets have slumped, but there are many good-quality businesses with strong balance sheets that are generating sufficient cash flow to support progressive dividend policies. Equities are an unloved asset class at present, but many quality companies in sectors such as oil and pharmaceuticals are sitting at attractive valuations. Commodities also have a role to play within a diversified portfolio.

Our focus at present is on gold and silver, rather than economically sensitive industrial metals. We regard the former as a hedge against the longer term inflationary implications of the action being taken to stimulate the economy, specifically low interest rates and the expansion of the monetary base.

We believe that successful investment is about managing risk, sensible diversification and taking advantage of opportunities as they occur.

Michael Kerr-Dineen is chief executive of Cheviot Asset Management

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