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How Savvy, Rich Investors Are Preparing For More Global Stress

Date: Friday, June 22, 2012
Author: Kenneth Rapoza, Forbes

Global economic fundamentals are not sound.

The U.S. economy is the shining star of the world’s major economies, and it needs Fed Reserve life support to grow over 2 percent.  The Federal Reserve Bank will extend its Operation Twist program, a bond buying program that forces interest rates to historic lows and weakens the value of the dollar.

The No. 2 economy in the world, China, continues to pump out disappointing economic data, with HSBC Flash PMI data yesterday showing lackluster business sentiment, now down to 2009 crisis levels.

The sky is not falling in Europe, but it’s still dark and stormy. Still, that’s better than a eurozone Apocalypse as many were forecasting to occur within three months. The euro will survive, big money managers say, and that’s ultimately good for the global economy. But as the European Union works itself out of a very deep hole, and the U.S. economy remains on at least partial life support, there will be stresses in the market. There will be volatility. There will be 20 percent dips in retirement funds.

Stress around the euro area has returned since Sunday’s election in Greece.  The euro’s future has dominated financial markets over the past few months. While investors have been through several cycles of increased stress followed by relief rallies in response to fire-fighting by policymakers, through it all the crisis has intensified.  It has spread to larger and more systemically important countries such as Spain and Italy and required increasingly bigger policy responses. More importantly, market skepticism that a sustainable solution will be reached anytime soon has generated
increased capital flight that has tightened financial conditions, increased further the stress on local banks, and generated recession in the peripheral countries that greatly exacerbates the crisis around sovereign debt.

How are big money investors preparing for this?

In a 124 page report, Barclays Capital, one of the biggest investment banks in the world, gave their clients some advice on Thursday.

Here’s how big money is protecting themselves and will position themselves to make money even in dire straits.  From Barclays’ Global Outlook, published Thursday.

Equities Forecast

  • It’s till too early to adopt a more aggressive position in European equities. While we remain cautious in the short term, we see some value for investors with a long-term horizon.
  • For Central Eastern Europe, Middle East and Africa (CEEMEA) equities, we think positively skewed event risk will restore a degree of risk appetite this summer. However, markets will likely drift until 4Q12.
  • In the U.S., we expect a rally later in the year driven by stabilization in the global growth outlook, lower earnings expectations and election optimism.
  • Expect volatility to stay elevated for the rest of year, as the European crises shows no sign of abating.

Equities Recommendations

  • Within Europe, buy value-oriented and more defensive strategies. These include: exposure to the UK FTSE 100 versus the Euro STOXX 50 as well as high quality, consistent dividend payers.
  • Within CEEMEA, prefer Russia and South Africa and would underweight all three Central European countries. We would also underweight Turkey, too, although with a more positive outlook.
  •  In the U.S., we prefer defensive sectors such as Utilities, Healthcare and Energy; defensive stocks within cyclical sectors; and dividend payers.
  • Sell longer-dated Euro Stoxx 50 dividend puts as the dividend market seems to be pricing excessive pessimism. (Selling puts is bullish, and provides immediate income. Buying puts is bearish.)

Bonds Forecast

  • Modest growth expectations in the U.S., downside risk from the fiscal cliff and potential for a further rise in sovereign/bank concerns in Europe argue for rates to remain near current levels. A further rally cannot be ruled out.
  • Renewed peripheral stress in the euro area will continue to prompt further policy responses (European Central Bank rate cuts, a roadmap for a European fiscal union). While there is no silver bullet and headlines will remain a feature, their macro effect should fade.

Bonds Recommendations

  • A large rally should be led by the long end; conditional bull flatteners are attractive. Short 2y vs 10y straddles, as a large sell-off in rates is unlikely, and long front-end spread wideners to hedge against escalation in the European crisis. (Short straddles are moderately complex options strategies that provide immediate and one-time income.)
  • Short interest rates likely to be supported by expected ECB easing and abundant liquidity. Long-end rates may benefit but are already at low levels, so have more limited room for a rally. We like the five year sector debt in Europe, but the longer end in the UK (outright and cross market).

Emerging Markets Forecast

  • We have revised our EM growth and inflation forecasts slightly lower for 2012. Euro area developments remain a key risk for business sentiment and asset markets.
  • We see real EM GDP growth at 5.6 percent this year (down 10 basis points from the forecast at the end of Q1).
  • Policymakers have room to support growth, with Brazil and India likely to cut rates (100 basis points) in the coming 12 months.

Emerging Markets Recommendations

  • In interest rates, we favor countries where we see rate cuts or a repricing of monetary easing risks (Brazil, India and Turkey).
  • In credit, we prefer overweights where local demand and technicals anchor spreads (Philip., Turkey, Gulf Coast Countries and Brazil).
  • We like being short Central European currencies and long currencies which are oversold (Mexico, for instance) or benefit from global liquidity (Turkish Lira).

These are just some ways savvy and wealthy investors will try protecting their assets and growing richer from global stress.

It is of course very difficult for investors to position themselves effectively in this type of crazy and volatile environment. It is also tempting to simply run for cover and avoid risk altogether, wrote Larry Kantor, director of research of Barclays and lead author of the report. “The problem is that investors for the most part have already done this, so that asset prices are now priced to deliver historically high returns on risky assets relative to perceived safe assets such as Treasuries and German bunds. For investors who can tolerate the short-term volatility and who focus on medium- to long-term returns, it is wise not to veer too far from a neutral risk allocation. We believe that a disaster scenario is still a tail risk, and that there are risky assets outside of the euro area periphery that are likely to deliver returns well above what can be obtained on the dwindling group of safe assets, even as the euro crisis persists.”