Text published in Le Jeudi (Luxembourg) on 1 July 2014.

In developed economies, the investor has to contend with a triangle that is difficult to manage. At the base of this triangle are interest rates, which are set to remain particularly low for quite some time, and risk indicators which have turned green. Indeed the statistics issued by the American Federal Reserve suggest that the financial tensions have fallen to a historically low level, while in early April the Financial Times ran a headline saying that according to the IMF the risk of a cyclical reversal had become extremely weak.  These two elements (low risk and rates) encourage the taking of risks. In contrast, at the apex of the triangle, are the valuations which have become expensive for a good number of asset classes. This factor prompts caution or even risk reduction. So what to do in the face of this dilemma? Not taking risks means being certain to obtain very weak or even negative returns, taking into account inflation and the likelihood of missing some good opportunities. Taking more risks, on the other hand, is done at a cost, which is the cost of being hit by the consequences of a sharp fall in the markets at a given moment.

Faced with the impossibility of predicting with precision any such reversal, investors need to start by fixing their priorities, rather than opting blindly for one asset class or the other. Adopting an investment style depending on one’s economic needs, requires discipline: you need to make a list of your objectives and identify your main objective. Traditionally, there are four needs: the need for regular income, capital appreciation, capital preservation in real terms and maintenance of upside potential while limiting downside risks. When the price of financial assets is low and official rates could fall, there is no conflict between these objectives: everything rises in value. However, when prices are high and when there is a likelihood of official US rates rising in the course of next year, conflicts will become apparent. This is why investors must identify the objective they consider the most important, and if necessary adapt their portfolios accordingly. In this way, the portfolio’s downside risk will be more easily accepted if capital appreciation or even regular income are identified as primary objectives. More precisely, if regular income is the main objective, high dividend stocks, listed real estate companies, high yield bonds and emerging market debt would be most appropriate. For capital appreciation, one naturally thinks of equities and in particular, for valuation reasons, of European and emerging market equities. High yield bonds would also come under consideration. For capital preservation, one should target high quality government bonds, with maturities that are not too long, as well as highly rated corporate bonds. To maintain upside potential while limiting downside risks, one could use convertible bonds, strategies and funds which aim to protect the capital up to a certain threshold, or, for example, so-called “absolute return” or “total return” funds where the manager has considerable flexibility. To conclude, if at first sight there seems to be no solution to the investor’s dilemma, simply fixing priorities already allows more informed decisions to be taken, which creates a good basis for more detailed monitoring of markets and opportunities.

 

William De Vijlder

Vice – Chairman of BNP Paribas Investment Partners