Oil prices have climbed above $120 a barrel, partly in response to the loss of exports from Libya as rebels confront government forces
Dylan Grice, Global Strategist, Société Générale
Western government bonds are more dangerous than they look
To understand the risks we face, it’s important to understand that developed world governments are insolvent. Jagadeesh Gokhale, at the Cato institute, estimates that unfunded health and social security obligations in the EU are equivalent to well over 400 per cent of GDP. Larry Kotlikoff of Boston University, using data from the Congressional Budget Office, estimates the US shortfall at more than 800 per cent of GDP. These promises cannot be made good.
This leaves us in a fragile position indeed. On the one hand, “risk-free” government bonds pose significantly higher credit risk than their historically low yields imply. On the other, a move to higher yields that would more accurately reflect that credit risk would place intolerable strain on already pressured government finances, not to mention the serious threat to economic growth and employment. Central banks have already responded to the banking crisis by printing money to finance government deficits. Why would a bond market crisis be treated differently?
The path to persistent printing of money to finance government deficits—in the name of “keeping the economy on track”—now lies before us. Past inflation crises have shown where that path ultimately leads.
Diana Choyleva, Director, Lombard Street Research
US shares are near their peak. Look to Mexico and Japan
Two forces already in play are likely to shape the investment landscape in the next year and a half. China has to deflate its economy, while America has opted for a boom-bust. Beijing was too slow to rein in its red-hot economy, but since last autumn policymakers have become determined to curb inflation. Tightening too late and too much suggests growth is likely to slow substantially by mid-year.
American policymakers took the opposite stance. Monetary easing by the Federal Reserve and the fiscal boost announced by the Obama administration in late 2010 are likely to push US growth above trend in 2011, with the upswing intensifying in the second half. But the fiscal measures apply only to 2011, and reverse automatically at the start of 2012. In almost any scenario, US federal spending will fall significantly from here. US growth is set to slow sharply in 2012.
US equities have some upside left, but by summer they are likely to have peaked, with a downturn to follow. Long-dated US Treasury bonds could see their bear patch last longer than the bull phase for stocks, but they should rally sharply once the market starts to anticipate the US economic relapse. Chinese equities should be a no go zone.
Shorting commodities, especially metals, from the winter of this year should be a winning strategy. From the emerging markets, Mexican equities offer good value. Japan’s stockmarket should also be a good bet, although expect the yen to fall.
DeAnne Julius, non-executive director of BP and former MPC member
Buy global companies and real estate funds
At times like this it helps to stand back and consider the big themes driving the global economy structurally and cyclically. Structurally, we are in a two-speed world. Growth in Asia and other middle-income countries is strong and likely to remain so. Growth in the rich countries of North America, Europe and Japan is slow and their recovery from the financial crisis will be sluggish. Cyclically, we are in a global recovery phase. World growth is in the 4-5 per cent range and world trade is growing at twice that rate, pulling the trade-dependent parts of the slower economies along with the faster ones. This brings inflationary risks, exacerbated by keeping interest rates too low for too long in the developed world.
With all this in mind, the medium-term investor should allocate half or more of his or her portfolio to equities, favouring large companies with strong cash flows and good exposure to the high-growth countries. Real estate funds should also do well in inflationary times but be careful to diversify geographically since property market cycles differ across countries.
Stay away from government bonds and instead buy individual corporate bonds to hold to maturity if you want a long-term, higher yielding product. And to protect against those big geopolitical risks, put at least 20 per cent of your portfolio into hedge funds that aim to profit from exchange rate and commodity price volatility. Or, if you still can’t sleep and fear the worst, buy gold and hide it under your floorboards.
Jonathan Ruffer, Chief Executive, Ruffer LLP
The Japanese stock market will be the place to invest
It is obvious where the world goes from here: high inflation with interest rates well below the rate of that inflation. Unfortunately, the timescale is unclear, and, even worse, the longer this outcome is delayed the more apparent it will be that underlying economic conditions, at least in the West, are deflationary. In the credit crunch, the car burst a tyre, and has veered towards the left-hand ditch of deflation: the driver is responding (with quantitative easing) by turning the steering wheel towards the inflationary right-hand ditch. The right-hand side will win, because the deflationary left-hand side equates with the depression (an iconic no-go area in the US, which sets the world’s monetary policy). Moreover, the right-hand ditch gives the world a clearing system by transferring wealth from the saver (who is inconvenienced) to the borrower whose debts, presently unrepayable, are the menace of our economic system.
Japan will be forced to address its problems; structural reforms there will make this market the best of the lot but, again, who knows what the onset of the perfect storm (high oil prices, high yen, and a decrease in economic activity) will bring? Meanwhile, there will be concerns over banks and bonds, markets will fluctuate and the investment community will continue to pontificate about things of which they know nothing.
Jon Moulton, Chairman, Better Capital
Interest rates can only go up, which will hit government bonds
For me the thing to watch this summer is sovereign debt in the eurozone. If Ireland, Portugal and Greece default to avoid the next few generations having to service a huge debt load (an increasingly rational thing to do—how do you spell Canute in Gaelic?), then yields on sovereign debt generally will probably rise, dragging interest rates up behind them. With so much personal, corporate and sovereign debt around, the result would be a big downturn.
Interest rates in Britain are at 30-year lows—only determined printing of money with a total disregard for the damage to prudent savers and a tolerance for inflation have kept this unnatural state in place. Savers are seeing their savings eaten by inflation and borrowers continue to be rewarded for taking big risks.
Sometime probably soon, interest rates will rise. History, and logic, says it will happen and it will not be pleasant.
Diane Coyle, head of Enlightenment Economics
Invest in small companies to tap tomorrow’s innovation
The temptation for governments to opt for inflation as a way to reduce the real value of their debts will be huge. It’s enough of a risk for me to advocate index-linked savings products and real assets (commodities, precious metals and real estate), as short-term hedges against inflation. A lot of people share this concern: that’s why the price of gold has soared. In the longer term, though, there’s only ever one sound investment: innovation. It’s the engine of growth, the source of real returns.
Productivity-generating innovation is going to be all the more important for western economies (and China) that have ageing and in many cases declining populations. Many people forget that at any moment in time the returns to past investment have to come from current output; no matter how much you saved in the past, what you earn on it today will depend on how the economy is doing today. Even if people work until they are older in future, it will take a faster pace of innovation just to offset a declining supply of labour in the economy.
The moral is to invest in a range of young new businesses—because who knows which will succeed? Be prepared to ignore the bubbles that characterise exciting high-tech industries from time to time, and hang on for long-term returns.
Also in this month’s investment special:
Gavyn Davies, former chief economist at Goldman Sachs, assesses the prospects for global economic recovery.
Adam Posen, external member of the MPC, Andrew Balls, Pimco; Guan Jiazhong of Dagong Global Credit Rating, and Henry Kaufman of Kaufman & co set out the regional risks to growth.
PLUS Max Hastings on the aftermath of his DIY investment lesson from John Kay
Dylan Grice, Global Strategist, Société Générale
Western government bonds are more dangerous than they look
To understand the risks we face, it’s important to understand that developed world governments are insolvent. Jagadeesh Gokhale, at the Cato institute, estimates that unfunded health and social security obligations in the EU are equivalent to well over 400 per cent of GDP. Larry Kotlikoff of Boston University, using data from the Congressional Budget Office, estimates the US shortfall at more than 800 per cent of GDP. These promises cannot be made good.
This leaves us in a fragile position indeed. On the one hand, “risk-free” government bonds pose significantly higher credit risk than their historically low yields imply. On the other, a move to higher yields that would more accurately reflect that credit risk would place intolerable strain on already pressured government finances, not to mention the serious threat to economic growth and employment. Central banks have already responded to the banking crisis by printing money to finance government deficits. Why would a bond market crisis be treated differently?
The path to persistent printing of money to finance government deficits—in the name of “keeping the economy on track”—now lies before us. Past inflation crises have shown where that path ultimately leads.
Diana Choyleva, Director, Lombard Street Research
US shares are near their peak. Look to Mexico and Japan
Two forces already in play are likely to shape the investment landscape in the next year and a half. China has to deflate its economy, while America has opted for a boom-bust. Beijing was too slow to rein in its red-hot economy, but since last autumn policymakers have become determined to curb inflation. Tightening too late and too much suggests growth is likely to slow substantially by mid-year.
American policymakers took the opposite stance. Monetary easing by the Federal Reserve and the fiscal boost announced by the Obama administration in late 2010 are likely to push US growth above trend in 2011, with the upswing intensifying in the second half. But the fiscal measures apply only to 2011, and reverse automatically at the start of 2012. In almost any scenario, US federal spending will fall significantly from here. US growth is set to slow sharply in 2012.
US equities have some upside left, but by summer they are likely to have peaked, with a downturn to follow. Long-dated US Treasury bonds could see their bear patch last longer than the bull phase for stocks, but they should rally sharply once the market starts to anticipate the US economic relapse. Chinese equities should be a no go zone.
Shorting commodities, especially metals, from the winter of this year should be a winning strategy. From the emerging markets, Mexican equities offer good value. Japan’s stockmarket should also be a good bet, although expect the yen to fall.
DeAnne Julius, non-executive director of BP and former MPC member
Buy global companies and real estate funds
At times like this it helps to stand back and consider the big themes driving the global economy structurally and cyclically. Structurally, we are in a two-speed world. Growth in Asia and other middle-income countries is strong and likely to remain so. Growth in the rich countries of North America, Europe and Japan is slow and their recovery from the financial crisis will be sluggish. Cyclically, we are in a global recovery phase. World growth is in the 4-5 per cent range and world trade is growing at twice that rate, pulling the trade-dependent parts of the slower economies along with the faster ones. This brings inflationary risks, exacerbated by keeping interest rates too low for too long in the developed world.
With all this in mind, the medium-term investor should allocate half or more of his or her portfolio to equities, favouring large companies with strong cash flows and good exposure to the high-growth countries. Real estate funds should also do well in inflationary times but be careful to diversify geographically since property market cycles differ across countries.
Stay away from government bonds and instead buy individual corporate bonds to hold to maturity if you want a long-term, higher yielding product. And to protect against those big geopolitical risks, put at least 20 per cent of your portfolio into hedge funds that aim to profit from exchange rate and commodity price volatility. Or, if you still can’t sleep and fear the worst, buy gold and hide it under your floorboards.
Jonathan Ruffer, Chief Executive, Ruffer LLP
The Japanese stock market will be the place to invest
It is obvious where the world goes from here: high inflation with interest rates well below the rate of that inflation. Unfortunately, the timescale is unclear, and, even worse, the longer this outcome is delayed the more apparent it will be that underlying economic conditions, at least in the West, are deflationary. In the credit crunch, the car burst a tyre, and has veered towards the left-hand ditch of deflation: the driver is responding (with quantitative easing) by turning the steering wheel towards the inflationary right-hand ditch. The right-hand side will win, because the deflationary left-hand side equates with the depression (an iconic no-go area in the US, which sets the world’s monetary policy). Moreover, the right-hand ditch gives the world a clearing system by transferring wealth from the saver (who is inconvenienced) to the borrower whose debts, presently unrepayable, are the menace of our economic system.
Japan will be forced to address its problems; structural reforms there will make this market the best of the lot but, again, who knows what the onset of the perfect storm (high oil prices, high yen, and a decrease in economic activity) will bring? Meanwhile, there will be concerns over banks and bonds, markets will fluctuate and the investment community will continue to pontificate about things of which they know nothing.
Jon Moulton, Chairman, Better Capital
Interest rates can only go up, which will hit government bonds
For me the thing to watch this summer is sovereign debt in the eurozone. If Ireland, Portugal and Greece default to avoid the next few generations having to service a huge debt load (an increasingly rational thing to do—how do you spell Canute in Gaelic?), then yields on sovereign debt generally will probably rise, dragging interest rates up behind them. With so much personal, corporate and sovereign debt around, the result would be a big downturn.
Interest rates in Britain are at 30-year lows—only determined printing of money with a total disregard for the damage to prudent savers and a tolerance for inflation have kept this unnatural state in place. Savers are seeing their savings eaten by inflation and borrowers continue to be rewarded for taking big risks.
Sometime probably soon, interest rates will rise. History, and logic, says it will happen and it will not be pleasant.
Diane Coyle, head of Enlightenment Economics
Invest in small companies to tap tomorrow’s innovation
The temptation for governments to opt for inflation as a way to reduce the real value of their debts will be huge. It’s enough of a risk for me to advocate index-linked savings products and real assets (commodities, precious metals and real estate), as short-term hedges against inflation. A lot of people share this concern: that’s why the price of gold has soared. In the longer term, though, there’s only ever one sound investment: innovation. It’s the engine of growth, the source of real returns.
Productivity-generating innovation is going to be all the more important for western economies (and China) that have ageing and in many cases declining populations. Many people forget that at any moment in time the returns to past investment have to come from current output; no matter how much you saved in the past, what you earn on it today will depend on how the economy is doing today. Even if people work until they are older in future, it will take a faster pace of innovation just to offset a declining supply of labour in the economy.
The moral is to invest in a range of young new businesses—because who knows which will succeed? Be prepared to ignore the bubbles that characterise exciting high-tech industries from time to time, and hang on for long-term returns.
Also in this month’s investment special:
Gavyn Davies, former chief economist at Goldman Sachs, assesses the prospects for global economic recovery.
Adam Posen, external member of the MPC, Andrew Balls, Pimco; Guan Jiazhong of Dagong Global Credit Rating, and Henry Kaufman of Kaufman & co set out the regional risks to growth.
PLUS Max Hastings on the aftermath of his DIY investment lesson from John Kay
