A number of high-profile managers including FE Alpha Manager Alastair Mundy have told FE Trustnet recently they are taking measures to increase downside protection and profit from a sell-off.AFI panellist Paul Warner, managing director of Minerva Fund Management, says that the current sense of calm in the markets could be short-lived.
“There’s a possibility that we could have a bigger correction than people might anticipate, because people have become too complacent after last year’s rally,” he said.
However, it is not easy to predict what events you need to protect yourself against.
The Ukraine crisis, expensive stock markets in the US, fears of eurozone deflation and ongoing concerns about China are all risks that haunt the markets, and all require very different responses from investors.
Here we look at what investors can do to protect themselves against the most likely scenarios.
Falling bonds and equity markets
Between May and July 2013, bond markets and equities were unusually both subject to a market correction at the same time, primarily in reaction to the Fed’s announcement that it would taper its stimulus programme.
Performance of indices over 1yr
Source: FE Analytics
This is an unusual event and has caused many investors to go back on their traditional bond exposure, requiring something else to be put in their place.
Warner says a similar situation could occur in 2014 depending on the depth of its tapering over the course of the year and the market’s reaction to it.
“If the Fed decides to stop QE altogether this year, then bond markets and equities could fall simultaneously again,” he said.
This would be similar to what happened in 1994 when the Fed’s then chairman Alan Greenspan doubled benchmark rates over the course of 12 months, Warner says.
“In this kind of event you don’t know what is occurring, so you wouldn’t know which way to move,” he said.
“You’d have to hold cash in order to plug back into equities, because when the correction ends, corporate bonds would be priced off.”
“However, you could also go for short-dated bonds or a short-dated corporate bond fund, which is very close to cash.”
A number of professionals have also increased their weighting to alternatives such as absolute return funds, hoping that they will provide uncorrelated returns to equities in such an event.
Rob Gleeson, head of FE Research, told FE Trustnet last year he was making this move.
Traditional market correction
Another possible scenario for a market correction would be a traditional sell-off of stocks over valuations or earnings fears.
Many managers have warned that earnings are not keeping up with valuations, and some of these, such as Sebastian Lyon, say this is likely to lead to a market correction at some point.
Traditional bonds would work well in such a scenario, which is why many professionals warn against removing them from your portfolio.
Any such sell-off would likely be temporary, presenting an opportunity to buy back into the market cheaply, Warner says. He recommends investors increase their cash exposure to about 10 per cent.
“Short-dated bonds are another option if you don’t want to hold cash. Because they’re short-dated, you shouldn’t get hit and you’ll get a slightly better income than if you hold cash,” he said.
Russia
The ongoing turmoil over the Crimean peninsula could potentially generate a severe market correction as fears of a prolonged stand-off and the effect of punitive sanctions against Russia hit market confidence.
In the case of war, gold may be investors’ best bet, because even if its record of protecting against inflation is in doubt, it does tend to do well in times of crisis.
Warner says that one way of reacting to the crisis could be to buy energy stocks, which should do well in such a situation.
The ability to take advantage of such opportunities is one of the reasons he recommends holding a high cash weighting.
“If Europe and the US impose severe sanctions, one of the options Russia would have is to turn the gas taps off, which would be a likely outcome,” he said.
“If it does get nasty and we start getting tit-for-tat sanctions, I would expect energy prices to rise across Europe.”
“That would definitely upset the economic apple cart in Europe, not so much in the US because they’ve got their own energy supply.”
Warner says this would be a great reason for investors to switch into energy stocks or funds with a high exposure to this sector, but advises them to stay away from the Russian energy giant Gazprom.
Deflation
Deflation in Europe is much more likely than in the UK, but with many UK stocks heavily geared towards the European mainland, investors should bear in mind its potential to cause a severe correction, Warner says.
In such a scenario, holding a weighting to high-quality sovereign or corporate bonds would be the best option, he says, although even cash would increase in value.
“I think deflation could be a big problem,” Warner said.
“It’s being caused by a lack of demand in Germany, which is supposed to be the motor of Europe and all they seem to want to do when things start getting better is more austerity.”
“If that deflationary environment occurs, then AAA corporate bonds would be a reasonable bet or you could hold gilts or a gilt fund.”
“If I have to hold gilts, I use the Allianz Gilt Yield fund as it is one of the most consistent performers relative to the sector, so it’s a good core holding.”
