Preparing clients for a rough ride

Against a background of deep macroeconomic uncertainty and with financial markets expected to remain highly volatile, it is more important than ever to take a fresh look at private investors’ portfolios and assess the right investment strategies for the new year.

“We expect financial market volatility to remain elevated in 2012,” says Steve Brice, chief investment strategist, consumer banking at Standard Chartered Bank. Financial markets will be dominated by policy decisions, and with the policy making process being extremely politicised at a time when there are leadership changes/elections in the three critical regions – China, the US and Europe (France) –uncertainty in the macro-economic environment will remain high, says Mr Brice.

As such, it makes sense to have significant allocation to asset classes that are either less volatile in their own right or significantly dampen portfolio volatility, as they have low correlation with equity markets, he says. Gold and strategies that can go long and short different asset classes, such as macro hedge fund/CTA strategies, which are expected to generate significantly positive returns in 2012, fit into this category.

Gold and gold stocks will also provide a good hedge against inflation, which remains a key concern.

The outlook on inflation is uncertain but policy makers will be very keen to avoid a situation where austerity plans turn into a destructive debt deleveraging cycle. “We expect an asymmetrically strong policy response to any emerging deflationary pressures versus rising inflation,” says Mr Brice. “This should mean that risks are skewed to significantly higher inflation rather than prolonged deflation.”

The hunt for yield continues and cash generating assets are particularly attractive in this very low interest rate environment. The focus is on high yield bonds and high yield equities, which generally outperform broad equity indices by a significant margin, in both the two market scenarios most likely to happen. “We see a 60 per cent probability of a ‘muddle-through’ or ‘mild recession’ scenario playing out in 2012, with 30 per cent probability of a deep recession scenario,” says Mr Brice, explaining that a strong growth outcome is predicted to have only 10 per cent probability.

More emphasis is put on diversifying portfolios, on riding through the ups and downs and averaging into assets offering long-term value. “We are very keen to stress to clients that volatility can actually be your friend. Equities are cheap on a standalone basis and extremely cheap relative to investment grade debt, and averaging in as markets remain weak in the short-term makes sense,” he says.

In the next three to six months, protection of wealth is absolutely key but, assuming Europe continues to make progress in addressing the crisis and quantitative easing continues in the UK and resumes in the US, equity and commodities markets will benefit. “We would be expecting to be advising our clients to add risk as we move in the second quarter of the year,” says Mr Brice.

Real assets

Hard assets, such as real estate, are appealing and they have drawn significant interest from Indian wealthy investors’ of late, explains Rajesh Saluja, CEO at Mumbai-headquartered Ask Wealth Advisors. “We are bullish on the residential real estate segment in India, where there is a huge demand supply gap,” he says, predicting demand for loans and homes will increase further as interest rates in the country start moving downwards.

In India, where Reits (real estate investment trusts) or real estate mutual funds are not available, the only way to take exposure to real estate is through private equity funds, which across the industry have gathered close to $500m dollars from wealthy clients over the last couple of years.

Indian investors are allowed to invest only $200,000 in international products per person per year and they are not allowed to leverage. But even so, they rarely take advantage of their full allowance and prefer to invest in the more familiar domestic market.

“The opportunity in India itself is so good that people are more keen to invest in India than looking outside,” says Mr Saluja.

The depreciation of the Indian rupee by 20 per cent against the US dollar over the past six months has affected stocks with high import bills and business sentiment, as many high net worth individuals are exposed to the US dollar through their firm.

However, despite current concerns over high interest rates, a tight monetary policy and high inflation, the Indian economy is expected to grow at 6.5-7 per cent at least for the next couple of years and 8-9 per cent onwards. The domestic economy is well balanced and less dependent on exports than its neighbours, says Mr Saluja.

India’s greatest advantage is its demographics and burgeoning workforce. The government should also be able to implement policy reforms and infrastructure spending put on the back burner for the last two years and policies attracting foreign investment and improved corporate governance will also boost money inflows.

“Money will chase growth and we see higher allocations coming into India,” says Mr Saluja. “We are still advising clients to build Indian equity portfolios but remain focussed on large caps that are making strong profits, which are insulated in some way from what's happening in the global scenario.”

Because of the high downside volatility in equity markets, bonds have been very popular in the past two to three years, he says. “Given the high interest rate scenario, you still find very good opportunities and clients have been earnings 9-10 per cent on bonds, which is much higher than people earn in equities globally.”

The reduction of risk assets in portfolios is a common theme across Asia. “Before the European debt crisis, people liked to invest more aggressively, for example in single country funds,” explains Barry Chen, head of private banking at Taipei Fubon Bank in Taiwan. “But nowadays we encourage our clients to either take the profit or cut the loss and shift their money to more conservative single A or double A bond funds or just saving deposits.”

Since the S&P downgrade of the US debt in August, the percentage of investment assets held by Fubon private banking clients in their portfolios has reduced from 45 to 20 per cent. The percentage of risky assets has also decreased, from 15-20 per cent to 5 per cent.

“We are predicting there may be more bad news on the global markets at the beginning of the year and there may be a bigger correction in equity indices,” says Mr Chen, noting that the Pigs (Portugal, Italy, Greece, Spain) countries’ government bond maturities are concentrated in the first and second quarter of 2012.

“However, Taiwanese wealthy investors have tons of cash sitting aside to get through the current storm and when the next rally arrives, they will have a good chance to get in.”

Gold and commodity dollars, such as the Australian or the New Zealand dollar, are used to hedge inflation, while energy and emerging market equities, in particular, Southern Asian, Thai and Chinese equities, are recommended to investors wanting to take some risk.

Taiwanese investors are “heavily in love with the China story”, he says. The Chinese economy is expected to recover faster than the US and this may offer a good chance to get into equity markets at the beginning of the year.

“The Taiwanese believe China will lead the GDP growth in the world and if you really need to choose a country to put your money in, any China-related investment is a good choice,” he says. Last year China’s imports of services and goods exceeded exports for the first time, lending strong support to the domestic growth story, adds Mr Chen.

But Kelvin Blacklock, CIO, global asset allocation at Prudential Asset Management in Singapore, warns of a potential slowdown in China and a busting of the property market bubble next year. “China is displaying many classic symptoms of a property bubble – cheap financing and government support have fuelled a construction boom, which like all bubbles, must end.”

With supply rising sharply as demand slows, that end may be in sight. And if this bursts in the same manner as those in the US, UK and Spain, the fallout could be more painful than many anticipate, says Mr Blacklock.

Equity markets have not adequately discounted this risk and other key issues, such as Europe’s ongoing sovereign debt and banking crisis and the fact that the US is experiencing its weakest recovery in post war history. Global equity valuations only appear low because profit forecasts are too high, based on the fact that in recent years companies have been very good at cutting costs to protect their profit margins, which resulted in very high earnings. But this process has run its course, as profits are rolling over as growth detoriorates, he believes.

In the equity space, Mr Blacklock is overweight Japan, Germany and the UK, but he has no exposure to emerging markets. “These markets are too highly leveraged to China’s growth, which in turn is too highly leveraged to real estate investment,” he says.

In the short-term, Standard Chartered also recommends being underweight emerging markets and Asian equities, which are high beta and more volatile, because of currency weakness, explains Standard Chartered’s Mr Brice. Yet he emphasises that the Sharpe ratio for emerging market equities is better today than for developed market stocks.

This view should change over a 12 month period, he expects.

“On the longer term basis, we do prefer emerging market equities, with China being one of our top picks,” he says. The multi-year shift into emerging market currencies is forecast to resume from Q2 2012. The US dollar, which will strengthen in the near term on risk aversion, will resume its downward trend as 2012 progresses, with quantitative easing a huge contributor. “Over the long-term Asian currencies will appreciate and that’s one of the reasons we are overweight emerging market equities on a 12-month term,” says Mr Brice.

In addition to China, Korea remains the most attractive market in developing economies, argues Joon-Hwan Cheong, chief of the portfolio management team, private banking business department at Hana Bank in Korea.

Korean investors have become more conservative as they fear a contagion of the Europe debt crisis, he says, but if the Korean equity market collapses as a consequence there could be a chance to buy at lower prices. “The Korean equity market is so strong, the fundamentals and the economic conditions will remain the same, even though the European crisis becomes bigger,” says Mr Cheong.

Mind games

Giving recommendations to private investors when markets are so unpredictable, and people’s emotions get so extreme, is particularly challenging.

“Some clients find this directionless volatility much harder to cope with than it was post Lehman’s collapse,” says Peter Brooks, head of behavioural finance, Asia Pacific at Barclays Wealth.

Post Lehman, investors would panic and know they had to sell to get emotional comfort. Today, there is a strong rational argument that investors need to be invested and should not try to fine tune short-term market moves, he says. Markets are choppy and trying to time them is almost impossible. But that directionless volatility almost leads investors to paralysis.

Today’s markets can be seen as an “investor purgatory”, as individuals are not sure whether they are going to head towards the investor heaven, if the situation improves or whether they are going to move towards the investor hell, argues Mr Brooks. “We are finding that capital protection really resonates with a large number of clients.”

At Barclays, two of the key dimensions to assess clients’ financial personality are the propensity to take on market volatility and anxiety. Very anxious investors need to be protected from the situations where panic becomes the dominating emotion. At the other extreme are investors who find it very easy to ride volatility. But then the danger is that they don’t reassess their portfolio often enough. “Individuals that have lack of stress reaction to market volatility often become trapped in less performing stocks, because they believe they will just ride the storm,” says Mr Brooks.

Selling a losing stock is hurtful but clients need to learn that holding any particular asset is the “opportunity cost” of being invested elsewhere, he says.