Don’t panic! DON’T PANIC! (starts to walk up and down excitedly)
– Lance-Corporal Jack Jones (played by Clive Dunn), Dad’s Army, BBC Television 1968-1977
Earlier this week a major UK bank told its clients to sell everything except high-quality bonds to avoid the effects of a looming global deflationary crisis. But is that really good advice?
RBS made the announcement whilst advising clients to be prepared for a ‘cataclysmic year’1 for markets. Andrew Roberts, the analyst responsible for the announcement, said that he’d already seen the bank’s red flags in the first week of 2016. He compared the mood in the markets with that of 2008 before the collapse of Lehman Brothers and the beginning of the global financial crisis (GFC), explaining that the bank thinks investors should be afraid.2
I’m not so sure. Usually in January I make forecasts for the year ahead. But 2016 looks more unpredictable than any year I can remember. There are very good reasons to believe that the global outlook may look gloomy at best for the medium-term but it’s quite another thing to forecast any decisive trend specifically within the next 12 months.
For that reason for the first time in my career, I’ve decided to hold back from forecasts, on the grounds that in such an environment quite frankly anything could happen, and instead try to explain just how to be ready for the best and worst case scenario and every possibility in between. That does not necessarily mean selling everything off in a wild panic.
Right sentiment but wrong statement
The RBS statement certainly made the headlines; but that kind of announcement concerns me because, if replicated by other large banks around the world, could cause widespread panic and thus hit prices in all kinds of markets – almost a self-fulfilling prophecy.
It’s fair to say that the reasoning behind the bank’s announcement may be sound. Central bankers have been talking up economic performance up in recent weeks, such as Fed Chair Janet Yellen’s claim of “considerable progress”3 in the US, as she raised interest rates by a measly 0.25% (if things are that good, why not go higher, Janet?). Yet it doesn’t feel like the world is recovering from the GFC.
In fact I’ve been explaining for some time that the global economy appears to be heading for another crisis potentially greater than the GFC because the real problem wasn’t identified in the first place. Many of the elements are there: plummeting oil4 and combined commodities markets;5 extremely low inflation in the Eurozone and the US;6 continuing high levels of private debt;7 and this time China is in no position to soften the blows, as it did seven years ago.8
It’s believed that the People’s Bank of China spent USD 500 billion to support the Yuan in 2015.9 RBS analysts reckon that the currency would need a devaluation of as much as around 20% to be reached before capital outflows from China start to ease, so that it could support the global economy.10 Central bankers haven’t thoroughly understood that private debt caused the problem and that have relied too heavily on China.
If we add non-economic factors such as war, global terrorism and environmental issues to the cocktail, it is clear that the world is facing some huge socio-economic challenges.
Individual investors
So what should the individual investor do? One thing that’s clear is that no-one should panic. After all, it’s not as if this scenario has crept upon us. Instead we should expect markets – and consequently portfolios – to be vulnerable to severe corrections.
How much you’re affected by dropping values of course depends on the nature of your investments. If you’re very exposed to risk assets, such as commodities, stocks or property, you could be in for a very nasty shock – I frequently analyse portfolios that are widely touted as being suitable for ‘typical investors’ (whatever that actually means) that our proprietary risk models indicate could fall by 60% or more.11 Needless to say, this realization comes as a huge surprise to investors but at least we’re able to give a ‘heads up’ on this, rather than investors finding out the painful way.
If, however, you’ve opted for a balanced asset allocation designed in a way bespoke to your own risk profile, time horizon and liquidity and currency requirements, then you’re likely to be much better positioned for the current turbulence.
I’m in no way suggesting investors close their eyes and hope for the best or saying that everything will turn out OK in capital markets in the long run (because that can sometimes be a very long run, longer than the life expectancy or patience of investors).
It’s important to be sure your assets are allocated, as much as possible, to meet your target risk-level with which you’re comfortable. As I have often remarked, investors can control how much risk is in their portfolios – that is an input. They can only influence the returns that they get as an output from their investments.
However, that doesn’t allow room for complacency – markets are movable targets and risk allocation should be analysed regularly by an independent expert. Risk of loss and correlations are not constant.
The point is to ensure decisions are taken objectively, without loyalty to a particular asset that, for example, may have done well in the past but looks like flagging in the future.
To give you a theoretical example: if someone has a retirement or education fee plan due to mature in 15 years’ time and its value has dipped by say 10% in the last six months or so, that is not necessarily cause for alarm and doesn’t mean that they should press the panic button and decide to get out immediately. That person should, however, be aware of his/her portfolio. They should ask whether they expected that kind of performance in these kinds of markets and how vagaries of the uncertain future that we all face might continue to impact the range of possible returns that they face. The key, even in today’s unpredictable times, remains that each investor still has the ability to control their investment risk.
Allow some tolerance
With that in mind, my recent advice has been to plan investment to allow the possibility that we might see far greater falling prices along the way whilst having solutions ready to allow for any possible scenario. Allowing for any possibility means a greater reliance on risk management and that may imply a need to lower return expectations.
Right now I feel that’s the way forward until we have a major event or a clearer picture that suggests a change in strategy. Sadly the one prediction that I will make is that too many professional and non-professional investors will get caught out by being unprepared for the challenges ahead. In any environment where almost anything can happen, the key is to take the steps to make sure that you’re not caught unawares.
Footnotes:
1 http://money.cnn.com/2016/01/12/investing/markets-
sell-everything-cataclysmic-year-rbs/
2 ibid
3 http://www.ft.com/intl/cms/s/0/46a9001a-a424-11e5-8218-
6b8ff73aae15.html#axzz3x0GN1DFs
4 St Louis Federal Reserve
5 http://www.bloomberg.com/quote/BCOM:IND
6 Eurostat and St Louis Federal Reserve
7 http://www.telegraph.co.uk/finance/economics/12093807/
RBS-cries-sell-everything-as-deflationary-crisis-nears.html
8 http://www.mbmg-investment.com/in-the-media/inthemedia/59
9 http://money.cnn.com/2016/01/07/investing/china-
foreign-reserves-yuan-currency/index.html?iid=EL
10 http://money.cnn.com/2016/01/12/investing/
markets-sell-everything-cataclysmic-year-rbs/
11 MBMG Prism proprietary risk models
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