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01 Oct 2010

Managing Equity Risk During Uncertain Times

Dane Schrauwen, Foord Asset Management

The American comedian, Evan Esar, says that statistics are “the only science that enables different experts to draw different conclusions using the same figures.”  This tongue-in-cheek definition certainly rings true during these uncertain economic times.

Global economic statistics are released daily and interpreted by economists and so-called “experts”. At their extremes, the widely divergent views are for either a double-dip recession or accelerating growth and investors are just as confused, which has resulted in substantial price volatility in equity and bond markets.

The economic data coming out of the USA has certainly been disappointing:  The US housing market is struggling and anaemic job creation has restrained consumer spending.  But not all news has been poor, with strong corporate profits, rising manufacturing production and the US GDP per worker setting new records, all pointing towards growth, and if growth continues job creation and consumer spending will follow.

However, in Foord’s view, the most likely outcome is a middle of the road, “muddle through” scenario in which recession is avoided but growth remains relatively muted.  Even if a double dip recession is avoided, high consumer and government debt will have to be worked off over the next decade or so - which will be done primarily through higher taxes from governments and higher savings from consumers.

Although unexciting from an economic perspective, this scenario has profound implications for investment markets, which have already priced in the possibility of recession and deflation.  Bonds offer very low yields while shares offer very attractive yields (especially if one believes forecast earnings). In a muddle through scenario, earnings are unlikely to be as high as current forecasts predict, but this has already been largely discounted in share prices. In contrast, the bond market has already priced in little or no inflation.  Even in a mildly inflationary environment, the 2.7% yield offered on US ten year treasuries offers no protection.

In a worst-case scenario (i.e. recession), a diversified portfolio of equities, comprising a judicious mix of good quality growth and defensive shares, coupled with a reasonable cash holding, should offer sufficient protection.  Government debt should be avoided, despite the possibility of further gains.  If growth and inflation surprise on the upside, a conservative portfolio of shares, property and cash will benefit while bond investors sustain heavy losses as yields rise and bond prices fall. 

While we believe that the balance of probabilities favour a growth scenario, the risk of recession and deflation is not negligible.  As long-term investors, the prudent course is to construct a portfolio that favours growth but nevertheless offers protection in the event of recession.


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