Is it time for investors to come out of hibernation?

Investors remain nervous and are still heavily invested in cash, but are they doing the right thing? How serious is the threat of macro issues, and when will it be the right time to go back into the market? Dominic McCormick investigates.

At the time of writing (late June 2011) investors remain nervous.

This is reflected in various investor surveys, declining consumer sentiment, the recent 10 per cent share market correction and the fact that the Australian market – along with most other markets if measured in Australian dollars – has gone nowhere for the last 20 months, despite high levels of volatility.

It is also reflected by the fact that cash and term deposits are clearly dominating investor preferences and allocations, and have done so for much of the period since the global financial crisis (GFC). Term deposits at banks have grown by $190 billion (73 per cent) in the last three years to April 2011 and $58 billion (13 per cent) in the last year. 

Of course some of this preference for cash and term deposits is entirely rational. Available cash returns of 5 per cent per annum and term deposits above 6 per cent per annum are attractive in an environment where other asset classes are struggling.

Australia is one of the few countries in the developed world where you can earn a decent real return – at least pre tax – from cash-related investments.

In my company’s defensive portfolios, term deposits were introduced as a component around 18 months ago for the first time in their eight-and-a-half year history. In contrast, I was recently in the United Kingdom where 0.5 per cent per annum cash rates and 4.5 per cent per annum inflation is leaving savers enormously frustrated – and leading to some dangerous activity as investors blindly chase yield in a range of other assets.

Yet it is worth questioning whether this risk aversion has gone too far, particularly following the most recent market weakness, increasing pessimism and near saturation coverage of the major macroeconomic challenges facing the global and local economies.

The increasing risk is that some long-term investors responding to this environment are ending up with under-diversified portfolios which are almost totally reliant on cash and term deposits, and missing the better value now showing up in many investment areas.

Encouraging signs

Value in selected equities and equity markets is clearly improving, and return prospects look better than they have for some time. Forward price/earnings (PE) multiples of most markets are now towards the lower end of historical ranges in the low teens, while some of the world’s best businesses are at the high single digit level.

However, it remains a confusing environment for investors.

Some longer-term measures of valuation using trend earnings over extended periods remain above fair value.

This partly reflects the current higher-than-normal level of profit margins and also the unusually severe earnings impact from the GFC.

Further, with macro factors largely driving market indices in the short term – accentuated by the growing use of exchange-traded funds (ETFs) and other passive funds – there is a strong case that the better value is somewhat stock/sector specific, suggesting that good active funds rather than index/quasi-index funds are better placed to exploit the value appearing in many markets. 

Still, the biggest asset allocation decision confronting most investors in the current challenging environment is whether, and when, they should move some funds from the perceived safety of cash and term deposits to more growth oriented investments.

But what about the major macro risks that are so prominent?

The list of key issues includes sovereign debt concerns in Europe and elsewhere, a possible China hard landing, a marked slowdown in the US economy (perhaps triggered by the end of the second round of quantitative easing, or QE2) and rising inflation globally (most obviously in emerging markets).

Surely, these issues could cause a lot of damage to economies and equity markets, and are a valid reason to stay on the sidelines for now. But are these issues being too heavily emphasised? Are they already priced into markets? 

Let’s look briefly (and rather simplistically) at the ‘bear’ and ‘bull’ cases for each of these key issues.

Sovereign debt 

Bear case: Greece will default soon, causing a cascade effect leading to further problems in other countries as well as European and global banks.

The Euro will partly break up, and global financial markets will freeze much like 2008. There will also be an increased focus on the sovereign debt concerns of other developed nations such as the US, UK and Japan. 

Bull case: Greece may or may not default, but who cares?

Any problem banks will be bailed out, and the debt issues of other European countries will be resolved over time with modest flow-on impacts. The US and other indebted western countries will eventually act to solve their own sovereign issues. 

China hard landing/major slowdown

Bear case: China is a bubble that is close to popping. Too much capacity in housing and infrastructure has been built, and the current tightening measures will cause a dramatic economic slowdown and asset price collapse. China’s banks will have a lot of bad debts.

Commodity prices and particularly Australia will suffer badly as a result.

Bull case: Chinese authorities want and need a modest growth slowdown to ease temporary inflation pressures, and they are succeeding. This should enable the longer term secular growth story to continue.

Commodity prices, while volatile, will remain well supported in the longer term. 

US growth weakness

Bear case: The US is slipping into a double-dip recession. Housing prices have resumed their falls, and unemployment is likely to remain high.

Profit margins in the US are unsustainable and bond rates need to rise given fiscal concerns. 

Bull case: Mid-recovery slowdowns are common. While the problems facing the US economy are serious, corporate America is in good shape; and despite the end of second round of quantitative easing, monetary policy will remain loose for some time.

Equities are cheap versus recent history. 

Inflation 

Bear case: Commodity prices and wage pressures are causing inflation pressures, especially in developing economies but increasingly in developed economies.

Short and long-term interest rates will have to rise, putting pressure on all asset valuations.

Bull case: Higher inflation is largely a temporary issue, with recent commodity price weakness having already eased this pressure somewhat.

In any case, even with gradually rising inflation, real interest rates are likely to stay low to stimulate economies, thereby providing support for risky assets. 

Putting it into perspective

All these macro issues are clearly serious, and it makes sense to consider the potential impact of adverse scenarios where these issues significantly worsen and/or badly impact markets.

It also makes sense to consider adding some hedges or certain investments to portfolios that could protect (or at least not suffer major damage) if the bear case plays out.

But it also seems to me that most of these issues are already well publicised, discussed and clearly at the forefront of investor concerns. 

Further, markets currently seem obsessed with the bearish/negative side of each of these issues. This suggests that bad outcomes from each are already at least partly priced into markets, although it is difficult to determine by how much.

The possibility that these issues will be resolved positively – or have limited impact on most global markets or economies – is far overwhelmed by discussion of the potential damage they could do. 

For these macro issues and risks to continue to drive share prices down, it is likely they need to worsen or new major negative issues need to emerge.

If these issues don’t worsen, or even improve, the line of least resistance for many ‘risk’ assets is likely to be up when investor sentiment is so negative.

Many investors have already reacted to these fears and made their portfolios more conservative. As one strategy piece on Asia, but applicable to all markets, questioned about the current environment: ‘How about upside risk for a change?’

Of course with 2008 still fresh in many memories, there is much fear of a re-run of the GFC. You can see it in the way a potential Greek default is described as Europe’s ‘Lehman moment’.

But there is a key difference: a Greek default clearly is expected, whereas a disorderly Lehman failure clearly wasn’t. Greek bonds are already fully pricing in some form of default within the next couple of years. 

‘Tis an ill wind

It seems a legacy of the GFC is a greater focus on negative news among investors, and in the financial and general media.

Bad news leads to poor investor sentiment, which leads to more bad news being reported.

Perhaps it’s because the GFC showed starkly that very bad and almost unprecedented financial developments can occur. But now we seem to expect them every second month.

This is not to downplay the very real risks to the global economy and financial markets that include, but are not limited to, the risks discussed above.

But some things have changed since the GFC. Much of the private financial leverage around investments that led to the GFC being so violent for financial markets has already been significantly reduced or unwound.

While this has been replaced by a major public debt problem in some countries, authorities have become much more focused on resolving the problems.

There is no certainty that the problems will be resolved smoothly, but it is reasonable to suggest that the authorities have a plan B if things become disorderly quickly.

Further, while some of these macro issues are certainly likely to be major problems for the global economy at some point in coming years, they may not necessarily be problems in the near term.

For example, a severe slowdown in China is inevitable at some point – and it seems unlikely we will get a resolution to the sovereign debt issues of most indebted western nations without some serious pain.

But these events could be years away, and even when they occur they may or may not badly impact financial markets. 

Major crises typically start in environments of complacency and excessive optimism, not the current high levels of caution and pessimism.

It would therefore not surprise me if markets experience a strong rally out of the current pessimism. That is not to suggest that such a rally would be the beginning of a multi-year uptrend or that such a gain would even be fully sustained, but for those who have largely given up on growth assets the current pessimism seems to offer an attractive window to add for the longer term. 

The shortcomings of cash

Now is also an appropriate time to highlight that cash and term deposits will not be good investments in all future scenarios.

While perceived as ‘risk-free’ assets, there are times when they are a poor investment in a portfolio.

And this is not just that the current premium over official cash rates that banks are willing to pay to attract deposits is unlikely to last. 

One such scenario is where inflation takes off to much higher levels and current term deposits and cash look poor in real terms (ie, after inflation).

Some suggest that if this happened, cash and term deposit rates would rise in response, but there is no guarantee of this.

Just look to the examples in Australia’s history where cash returns in real terms were significantly negative (eg, much of the 1970s), or even countries now such as the UK where cash rates are 4 per cent below the current inflation rate. 

Another scenario is where the Australian growth outlook deteriorates quickly (perhaps with a major China slowdown) and cash and term deposit rates fall quickly and sharply, following big cuts from the Reserve Bank of Australia. Ironically, such a scenario may eventually be quite positive for growth assets.

This is because falling interest rates and a lower Australian dollar support the local share market (and unhedged overseas returns), and investors become starved of return in cash/term deposits and stampede for the attractive yields on offer in many shares. 

For most long-term investors, excessive reliance on cash and term deposits is therefore not a panacea for struggling portfolios, despite the case for maintaining a reasonable exposure now.

As usual, a dynamic approach reacting to the available opportunities and prospects makes sense.

As we head into what have historically been the more difficult months for share markets, there seem to be plenty of excuses for investors to sit on their hands and hold cash.

But markets have a tendency of moving in ways that cause the most number of investors the highest level of regret, and in my view a sharp rally that leaves many investors behind would be such a move.

Now, in my view, it is therefore a good time to be taking advantage of growing pessimism to add selectively to equities for the long term.

Such additions could be staged and targeted at periods of serious weakness. If one or more of the major macro challenges described above does cause a further major market selloff, investors may well get an opportunity, and should be in a position to add more, at even lower levels.

But there is no certainty such major selloffs will occur. Those investors complacently boasting about how comfortable they are in cash and term deposits are at risk of being the last to move, only prepared to buy when the macroeconomic environment ‘feels’ much better, which will almost certainly be at significantly higher prices.

By then, much of the good value and the better prospective returns from many equities will be gone. The current dilemma for investors and advisers is highlighted by the words of Warren Buffett: “Investing is simple, but not easy”.

Dominic McCormick is the chief executive officer of Select Asset Management Limited.