Is your money protected?
The looming public sector job cuts in the UK and weakness of the US recovery have led many experts to predict a double – or even triple–dip recession.
It's not hard to foresee what that means as far as job losses, slowdowns in consumer spending and the housing market, and general economic gloom are concerned.
But what could a double-dip recession mean for your funds, and how are the fund managers looking after your money in preparation for this?
Investors could be forgiven for being confused by the available data. On the one hand, the Bank of England has warned that the UK recovery is likely to remain 'choppy' and has revised its estimates for economic growth in 2011 downwards, from 3.5% to below 3%.
At the same time, inflation remains well above the Bank of England target rate of 2%, raising the prospect of higher interest rates.
Furthermore, the UK often follows the path of the US, where economic data has continued to worsen. US unemployment figures are still rising, the housing market shows no sign of improvement, and the Obama administration continues to run an eye-watering government deficit with no hint of austerity measures ahead.
But a double dip is not a foregone conclusion. UK economic data has been surprisingly resilient, with economic growth of 1.2% over the second quarter of 2010 helping to boost markets.
Unemployment data has continued to improve, suggesting that the private sector may be strong enough to fill the void created by public sector job losses. Some of the UK's largest trading partners – notably Germany – have also shown strong economic growth.
Part of the problem is that there remains no clear definition of a 'double dip'. The Policy Exchange, an economic think-tank, defines it as when, "following a recession, after a period of growth but before the previous trend level of output, there is a further period of contraction"
In other words, a second downturn in economic growth after a partial bounce-back from recession. But some have taken it to mean simply a recession that happens sooner than might be expected, given the normal economic cycle.
Anthony Nutt, manager of the Jupiter Income fund, says: "There is a problem with definition. After the Lehman crisis, the market looked over the precipice and decided that although the financial system was close to collapse, it would not go under.
"I think it is very unlikely that we will return to that sort of exceptionally bearish scenario." He thinks the most likely scenario is a long, slow grind to an improving economy.
Derek Stuart, manager of the Artemis UK Special Situations fund, agrees. "There is a risk that the austerity packages will tip the economy into a double dip as the existing recovery is fragile, but it is very difficult to call. UK consumers are paying down debt because of the fear of unemployment and not consuming as much. Either way, growth rates will be low for some time."
Richard Woolnough, manager of the M&G Corporate Bond fund, is more pessimistic, putting forward the possibility that the 50 years of economic expansion in developed markets may be at an end.
He says: "The interesting question now is whether we are seeing a long-term structural change in economic growth prospects. It has been three years since the credit crunch began, and the arguments that this is not a normal economic cycle are becoming more compelling."
However, most bond managers are following equity managers in their outlook for the UK economy.
Stewart Cowley, manager of the Old Mutual Global Strategy bond fund, says: "Although a lot of money has gone into the system, companies and consumers are using it to pay down debt, so the money is going nowhere. Inflation is likely to moderate from 2011 and there will be a long, slow recovery."
Safeguarding your porfolio
If this is the central case, how are fund managers positioning their portfolios? Stuart at Artemis is looking for companies with a strong enough product, and in particular a strong enough balance sheet (low levels of debt relative to assets, including cash), to withstand the economic turmoil.
The banks have reined in lending, so those companies with balance sheet flexibility can seek out opportunities not available to the rest of the market.
Favourite stocks include food supplier Booker C&C, sausage-skin maker Devro, which is under new management and is benefiting from changing eating habits in the emerging markets, and Wolfson, which makes audio chips for MP3 players.
Stuart adds: "The commonality between these stocks is that they are all well-financed, with strong management and a market niche." He is avoiding the cyclical companies that had a strong run last year.
Jeff Munroe, chief investment officer at Newton, says: "We like companies that are more exposed to a structural growth story. One of our major themes is the 'networked world', incorporating mobile, internet and email companies.
More traffic through iPads will help support the dividend of Vodafone, for example. And these companies are gaining strength in emerging markets."
The group also believes that changing demographics will continue to support the healthcare sector. Munroe points to pharmaceutical giant GlaxoSmith-Kline, which now has a dividend of 6%, growing at 7% a year.
He says that generally large companies have lagged through the downturn and look better value than many smaller cap companies.
Nutt too likes large caps. He believes the pharmaceutical sector looks good value compared to its history, and suggests that the insurance sector also has some scope for an improvement. He also sees good growth in dividends from here, which will favour some of the large caps.
It happens that many of these companies are also the least affected by economic downturns, which should protect a portfolio in the event of a double dip.
Ian Wells, UK investment manager at Aegon, says that even if there is a double dip, it may not spell disaster for the equity market, because companies are already leaner and meaner than they were.
"In the credit crunch, companies saw demand halving and inventories liquidated. They can't do it twice." He says that earnings and economic momentum, though slowing, are still a long way from a double-dip.
Can the UK cope?
Nutt agrees that the UK market has some headroom. "The UK market is the cheapest of the European markets relative to its 10-year history. It will attract foreign assets and there is likely to be more merger activity."
If anything, he is worried that the UK market might see a significant rally and get ahead of itself while the economic data remains uncertain.
Munroe believes that equity valuations also look attractive relative to bonds as a whole, but that investors need to be selective where they invest.
There are parts of the equity market that look very exposed if there is a double dip. The banking sector, for instance, may look healthier than a year ago, but it still has potential problems.
The choices in the bond market are less clear. Prices for gilts (UK government bonds) are at all-time highs, having benefited from the move to 'safe haven' assets. They are now yielding below inflation in some cases. The riskier end of the corporate bond market looks better value, but investors are likely to sell out if the economy deteriorates.
Ben Yearsley, investment manager at Hargreaves Lansdown, suggests leaving the investment decisions to the experts by using a strategic bond fund. Unlike other bond funds, these funds can invest anywhere within the bond market.
So, in the face of mixed economic signals, investors need to strike a balance between good-value but riskier assets that may go down if economic data weakens, and more defensive assets that may look expensive.
Most experts suggest the defensive end of the equity market offers the best value, with plenty of healthy dividends for sustenance.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.