By Harris Kynegou
Head of Private Banking
AstroBank Public Company Ltd
Low growth and inflation are the serious problems facing central banks today. The problem becomes even more complicated when those in charge try to fight one of the two, resulting in the other becoming worse.
The puzzle of the current situation in the global economy is the rising price of oil, metals, agricultural products and all commodities in conjunction with an already troubled supply chain. All this is causing a negative impact on the demand and consumption of goods and services. The Russian-Ukrainian war has been going on for a month now, which further complicates the situation, since it causes uncertainty, although after the initial shock it no longer has a significant impact on the stock markets. Added to the equation is the attempt by Western countries to hit Russia financially to get it to withdraw from Ukraine, a move that is putting even more upward pressure on oil and commodity prices, while the defence spending budget of several European countries has recently been increased. These funds will therefore not be channelled into infrastructure development, causing a deterioration in the growth of economies.
All this has pushed inflation upwards, so that it has already exceeded the increase in wages, without taking into account energy inflation. This means lower real income and consequently less liquidity available to citizens for consumer goods or investments.
The above are not the only pieces that make up the puzzle mentioned above. We should not forget that in the last two years central banks have injected huge amounts of liquidity into the markets and governments have increased their budget deficits to cope with the economic impact of the pandemic. These moves have in themselves created upward pressure on inflation (excluding energy prices) and have inflated equity and bond prices considerably. For example, stocks were trading at 20 times their gains while bond yields were at zero.
Before Russia's invasion of Ukraine began, markets were already discounting around six interest rate hikes (of 25 basis points) in America and a rate hike in 2022 by the European Central Bank. If Central Banks reduce the supply of liquidity with a consequent drop in demand for government and bank bond purchases, it will put even more pressure on markets and may lead to a new credit crisis.
US rate hike
Federal Reserve Governor Jerome Powel announced the first 0.25 rate hike, adding that now, at every Fed meeting, interest rates will be raised. This implies six increases, showing that the Fed is determined to tackle inflation. What Powel stressed is that the US economy is strong and any gloomy predictions of a recession are exaggerated.
I note that the amount of borrowing by both governments and corporations is at extremely high levels. Interest rate increases increase the cost of borrowing and will cause a decline in the values of companies. In addition to falling profits, there are also companies that will not be able to service their debt and will be forced into bankruptcy. An estimated 20% of the largest public companies in the U.S. will be unable to service their debt obligations unless they have continued inflow of liquidity (Zombie companies) (According to a publication of the New York State Society of Certified Public Accountants (CPA): (The Trusted Professional, Nov 17, 2020).
Meanwhile, the last few weeks have seen strong volatility in both stocks and bonds. Investors are cautious about the future predicting that companies cannot continue to make large profits given the negative impact of rising interest rates on their earnings. It is pointed out that even before the war prices were historically inflated.
An important factor driving markets is expectations and these are lowered when uncertainty prevails. Not just because of the war of course, although while it continues the risk of stagflation grows. Corporate profits will be clearly reduced due to higher commodity and energy prices and low demand.
So central banks have to be very careful how they limit and adjust monetary policy. The US economy, being more independent from Europe, will not be affected as much by increases in energy and commodity prices as well as the sanctions imposed on Russia. However, things are not as good for Europe. The European Central Bank will find it difficult to raise interest rates drastically and stop buying bonds. The consequences for the EU will be dramatic because, unfortunately, it is much more dependent on Russia for energy than the U.S.
In this environment, therefore, investment portfolios must adjust accordingly. The perspectives of a portfolio are two:
- Strategic Asset Allocation and how the funds are allocated to be able to absorb the shocks and volatility of the stock markets
- Dynamic/timely allocation, which clearly adapts more dynamically to each phase of the economic climate and to periods of time. Today's conditions therefore require us to reduce the risk of portfolios and adjust accordingly with more defensive options.
US stocks
It should be noted that there is a global trend towards a preference for US stocks over European stocks, due in part to the pressure on the euro against the dollar because the dollar acts as a safe haven. In addition, the pressure on the European economy due to the war is greater than in America and the rise in interest rates in the USA is putting downward pressure on the euro. So we will soon see the exchange rate move towards the unit, which will be reversed if, and when, things settle down.
As for bonds, the choice should be particularly careful for the reasons I mentioned above (high borrowing and the possibility of default). Investors should choose bonds with high coupons and short maturities. This way they can largely eliminate any negative effect of rising interest rates. And in this category, US corporate bonds are preferable to European and Emerging Markets.
Fixed gold
Portfolios should include a percentage of investment in gold, which is always a natural hedge against inflation and geopolitical crises. Gold is very likely to maintain its value unless sanctions are lifted and oil and commodity prices fall dramatically.
An important component of a well-structured portfolio is investments in alternative investments such as Hedge Funds, investments in real assets such as land and buildings and of course environmentally friendly (ESG) investments.Hedge funds (hedge funds and fund of funds) offer an excellent alternative option that is required to make up to 30% in any portfolio at all times.
But funds should be chosen that provide capital protection, give direct access to multiple investment strategies (which no investor can achieve on their own), have low correlation with markets and other portfolio investments, add significant diversification and portfolio protection but at the same time increase comparative returns in periods where markets are volatile and volatile.
But there is no one-size-fits-all formula. Each investor based on their level of knowledge, their goals, and most importantly the risk they wish to take, should, with the advice of certified investment advisors, plan their portfolio with a medium to long-term horizon and not always try to buy at the lowest level and sell at the highest.
Contents of this article including associated images are belongs Cyprus Times
Views & opinions expressed are those of the author and/or Cyprus Times
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