Preparing for a storm

It won’t be anytime soon, but an economic crunch is on the horizon … here’s how you can prepare.

Summary: Massive money printing, an impending inflation break-out with rising interest rates, and a China slowdown are all warning signs for investors that a big correction is on the cards – at some stage. It’s not a time to panic, but it’s good to be prepared, and there are ways to shelter from the storm before it arrives.
Key take-out: A clear danger signal for investors is rising inflation: but an imminent blow-out isn’t likely. Inflation-linked securities are a good counter to higher inflation.
Key beneficiaries: General investors. Category: Economics and investment strategy.

I first came into contact with Ashok Jacob when he was working closely with the Pratt Family and Alex Waislitz in innovative investment strategies that were designed to pick undervalued Australian companies.

In due course Jacob moved much closer to James Packer and indeed, for a time, he ran the Packer family investment operation. Since then Jacob has virtually gone out on his own and converted the former Consolidated Press subsidiary into Ellerston Capital, which manages around $3 billion of funds for either big institutions or wealthy global families.

I always like to pick up on how he is seeing the market – particularly if it is in accord with my view. Just before Christmas Jacob warned of overvalued sections of the sharemarket, particularly the technology sector, and some of the initial public offerings spun out of private equity firms.

It was very sound advice and was the precursor of a major correction in Wall Street technology stocks. Now he is taking us through another scenario. Basically, Jacob believes that the enormity of the money printing that has taken place in the US, Europe, Japan and China is creating an asset bubble which eventually will create a calamity. Politicians have no incentive to curb the avalanche of funds because it will make their political life much more difficult. He excludes Australia from these forces, but we will come back to that in a moment. Jacob believes that at some point this avalanche of money will cause inflation to break out, and when that happens interest rates will rise and the inflated share and bond prices plus other assets will create a major correction.

In the case of Australia, we have engaged in some money printing but nothing like the scale of others, and via Tony Abbott we are reversing the process. And indeed the response of the voters to Australia’s deficit reduction reversal is a good illustration of why politicians around the world are reluctant to go down that path. Jacob does not see a calamity in Australia unless China falls over. We were all given a reminder of the China danger this week when our sharemarket fell sharply in response to the fall in the iron ore price, which is closely related to the Chinese economy and of course the big increase in iron ore and coal supply the big miners have generated. And the long-term supply tap has not been turned off, with Rio Tinto set to increase production in Guinea and Gina Rinehart set to launch the Roy Hill project.

So what investment strategies need to be applied in these circumstances? Obviously one strategy is to put your money in the bank and wait for the downturn. The trouble with that strategy is the downturn might be quite a few years away, perhaps longer than five years. The reverse to that, of course, is to go full bore into equity markets in the belief that you will be able to pick when the downturn is coming. To a large extent, Jacob is doing that in global markets and backing his ability to pick individual stocks and to determine when the crunch is coming.

Can ordinary investors in the global market make such a determination? It is not easy, but a clear danger sign is inflation signals, so we will have to keep a closer look at global inflation trends. At the moment in the US there are some worrying inflationary trends, but bond yields have fallen because the bond market believes the US economy is going to be more sluggish than analysts and the US equity market are forecasting. This will curb inflation, indicating the Jacob scenario is not imminent. Bond markets have a good record in forecasting.

In Australia the tightening of the economy via Canberra and the fall in productivity growth in the last few years means there are a lot of Australian companies that will have very average performances in the next few years. It will be a time when you pick selected stocks.

In my portfolio I have a section where I have debt securities that are linked to inflation on the basis that I will get some degree of protection should inflation break out.

It will not be total protection, because the value of such securities will fall with higher interest rates. That also applies to infrastructure stocks, even where there is an inflationary hedge.

The answer is that where you want to stand on the equity investment curve is a function of your total position. If you have a comfortable level of savings then it makes sense to make sure your interest bearing securities are low risk with a similar strategy for and equity shares and property. A younger person looking to develop savings might take a higher risk profile. However beware of those crazy graphs that some financial advisors put out showing regular increase in equity shares and projecting them forward for the next few years showing them increase in a straight line. These graphs are particularly dangerous when you take pension and other strategic decisions based upon them.

If Jacob is right, then at some point in that upward graph there will be a substantial fall in the market and, as far as Australia in concerned, we will fall with global markets. But we are particularly vulnerable to what takes place in China and particularly susceptible to iron ore, gas and oil, which generate so much of our tax revenue. The reason we need to take such a strong line on government expenditure is that our tax revenue from the mining investment boom and mining revenue itself is on the way down, and that leaves a gaping hole. That has not been explained well by Tony Abbott and his people, and I don’t think the sharemarket fully understands it.

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