Who moved my risk?

Since 1940, when a bonito processing plant employing 200 workers failed, the Senkaku islands have been a deserted, historical curiosity to all but their neighbours. Controlled by Japan but 170km from Taiwan and 330km from China, these islands, along with North Korea, are a source of diplomatic convulsion.

China is now challenging Japan’s sovereignty of the islands. ‘The dangerous drift towards world war in Asia’ in the UK Telegraph quotes a Japanese official: ‘They are sending ships and even aircraft into our territory every day. It is intense provocation…This is one step away from conflict and we are very worried.’

If uninhabited, undistinguished islands can cause such apocalyptic headlines, no wonder Cyprus (pop. 1.1m) caused a few European hearts to flutter, especially those of Russian provenance.

The oligarchs deserve some sympathy. How were they to know Cyprus would be the place where the EU made a U-turn, punishing rather than saving bank bondholders and uninsured bank depositors? Dutch finance minister and Eurogroup head Jeroen Dijsselbloem called this a new model. Which it is, for Cyprus.

Banking crises

According to the IMF, of the 147 banking crises since 1970, this is the first where banks and their depositors have carried the can. On the prior 146 occasions, taxpayers shouldered the burden of the crimes and misdemeanours of others.

Mr Dijsselbloem quickly repositioned his comments, paving the way for a return to form. Should Spain, France or Italy ever come a cropper, the Cyprus model would be quickly discarded and the big banks would be supported at any cost. Fear of a bank run trumps good policy every time. Thus the crisis lumbers on, a perpetual risk that intermittently appears on our screens.

Meanwhile, the Japanese, with ambitions to double the money supply in less than two years, are buying a ticket in what The Credit Strategist calls the ‘Gutenberg sweepstake’. The prize – inflation, but not too much – may yet be a booby.

This is a roundabout way of saying that the global financial system remains precarious. The problems that led to the GFC – cheap money, poor risk management, greed, fraud and ineffective bank regulation – remain. The primary difference is that now the bankers know they’ll get bailed out.

The fact that the business press is talking about these issues much less frequently these days does not mean these risks have gone away. Indeed, some believe that there is a significant risk of an Australian recession in the next few years.

Occasional Share Advisor commentator David Lewellyn Smith of Macro Business, says that ‘the RBA is facing stiff headwinds in trying to rebalance Australian growth from mining investment to more traditional drivers like housing investment and consumption.’

With mining investment well short of the levels expected of it just one year ago, largely because China is moving away from commodity intensive growth towards consumption, Australia's terms of trade have declined 15%.

Recession risk

David warns that, ‘if this continues, Australia will face a combined income shock and investment decline in late 2013 that could trigger further business cycle retrenchment. As unemployment climbs and asset prices fall, there is a non-trivial risk of recession in 2014.’

We won’t repeat the regular sermons on how to prepare and manage such a threat (you can reread them here, here and here) but instead focus on a few fundamental truths, with some specific stock comments thrown in for good measure.

The first is that while investing in cash stops you from losing money, it also stops you from making it. Depending on your tax rate returns from cash probably won’t keep pace with inflation (see Blackrock – rethink the cost of cash). Hold cash by all means, but as an enabler, a way of taking advantage of opportunities, not an investment in itself. Keep it in a government guaranteed bank account or term deposit and keep maturities short.

As for that traditional refuge, gold, see The case for gold pt 1 and pt 2. We’ll be taking a more detailed look at the sector very shortly but if gold is a hedge in your portfolio then its falling price could pose an opportunity, although a highly deflationary environment wouldn't be good for any asset values.

Second, since the GFC the big four banks have increased their market shares and enjoyed a fall in bad debts. The big banks are now well capitalised, with the government and RBA driving earnings growth through first home buyer incentives and interest rate falls.

If the future for Australia's real estate market is more Japan (steady falls in home prices supported by extremely low interest rates) than the US (sudden and large falls) then the big banks will be able to earn their way through any problems without massive losses in their long-term value. We also know the government will support them at any cost.

That’s no guarantee of investment success from here but it is another reason to prefer the big four over the regionals, despite their larger dependence on overseas wholesale funding. If the future is more US than Japan, well, that’s why we have the 10% sector portfolio limit in the first place.

Lower commodity prices

Third, perhaps noting David’s comments, investors appear to be baking in lower commodity prices. We aren't deep into a cyclical downturn though, so we'd recommend prudence and sticking with quality. BHP Billiton, which is looking more attractive than it has done in some time, will shortly enter the Dragon’s Den so watch out for a review in the coming weeks.

As for mining services stocks, they’re looking much cheaper from an historical earnings perspective. But this is a sector we'd rather be buying when there's blood in the streets. As yet, the patient is merely weakened. In all sectors, the overall decision to invest should be driven by quality; our portfolios need to be stacked with stocks able to survive and prosper, even in a recession.

That’s certainly the case with our model portfolios, last updated in Portfolios back best ideas on 3 Apr 13. Both are invested quite defensively. If there’s genuine trouble ahead we don't expect the long term value of most of our holdings to change too much, despite any short term earnings falls. And we'd welcome any opportunities to invest at lower prices.

But what if you didn’t have the chance to invest in high quality stocks like CSL, News Corp and Woolworths when they were available at very attractive prices a few years ago?

Chart 1, which shows the powerful performance of the All Ordinaries Accumulation Index over the past two years, implies that obvious value is now harder to find. But with interest rates so low, there are still opportunities to earn respectable rather than stratospheric returns.

In What’s a satisfactory return now? Part 1 and Part 2, Greg Hoffman showed how seven of our current Buy recommendations and 13 Hold recommendations could be used to construct a portfolio of stocks delivering annual returns of 9% per annum, with relatively low risk. James Carlisle’s High yield and safe mini-portfolio story covered similar territory. These options are generally preferable to cash.

And of course, there are still occasional opportunities. In the first three months of this year Alumina, ALE Property, Sydney Airport and Silver Lake Resources have re-entered the Buy list. Tourism and leisure conglomerate Amalgamated Holdings, BWP Trust, online car classified site Carsales, property developer FKP and sleep apnoea specialist ResMed are all new to it. That’s not a bad haul.

But if you want high quality and cheap prices, you’re going to have to look beyond Australia’s shores. Steve Johnson’s first monthly report of Intelligent Investor International Fund explains why his most recent purchases have included Google, two supermarket chains – one in the UK and one in Singapore – an aspirational handbag designer and the bête noire of the GFC, AIG, with its shares trading at half book value.

That’s the difference between Australia and other markets: overseas, problems remain and tend to be priced in, which is why some stocks remain cheap; here, the risks are less apparent and stocks are more fully priced as a result.

With the dollar remaining strong, if you haven’t yet examined the possibility of investing some of your portfolio overseas, there’s still time to do so. This special report will set you on your way. If that’s not your bag, be patient. The recent run won’t last forever and when it cracks, we’ll be ready.