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Flight to quality in volatile markets Back  
The short-term outlook for developed economies may be poor but a well chosen long term asset allocation for a diversified portfolio will see investors through this difficult investment environment. Rory Quinlan looks at the different asset classes and sub classes that offer investors the best opportunities in the current markets including inflation linked investment and emerging markets property investments.
While the short-term outlook for many developed economies remains poor, it is not to say that there are no investment opportunities. Our view in HSBC Private Bank is the lessons for smart investors from previous crises are to keep a well diversified portfolio, avoid selling into panic and search out the investment opportunities which present themselves during these periods. The only limits are the investor’s own appetite for risk and their access to different markets.

A key fundamental of HSBC Private Banking’s portfolio construction is the focus on the strategic long term asset allocation. The strategic asset allocation decision will have the largest impact on realised returns compared to any other decision you take. The aim of the decision is to provide a roadmap for long term goals, given the level of risk that can be tolerated.
Rory Quinlan

In general, increased levels of volatility provide opportunities for trading strategies such as short-term trend followers and macro funds. The current market volatility is providing plenty of opportunities for many hedge funds. These might include funds that are going short on certain markets, more volatile commodity funds and other more speculative plays.

For example, there is a view at present that going long on the Dow Jones could prove a good medium term move for European investors. This is because the fall in value of the leading Dow stocks coupled with the near collapse of the dollar has created a situation where many of them are now around half the cost they were only five years ago. The question for investors is whether the dollar and the stock prices have any further to fall. For those prepared to take the risk that they are at or near bottom this may offer an excellent opportunity.

Conversely, there is also a view that the Eurozone may be moving into recession and that stocks on the German Dax may be overvalued, thereby offering an opportunity to go short. Again, risky but with the potential for high returns. The challenge is backing the right funds and it is worth noting that some hedge funds did encounter operating difficulties in the last quarter when they received unexpected margin calls as a result of marked to market losses.

Volatility will also remain the prominent feature of equity market behaviour over the next quarter. The current environment is driving a flight to quality with growing demand for large capitalisation stocks with strong balance sheets and those higher quality companies that have suffered unduly in the current market environment. Indeed HSBC has witnessed this flight to quality with a year on year increase of 22 per cent on deposits in 2007 to $1,096 billion.

This is not a time to panic sell, but neither is it a time to invest everything at once as better entry levels may be achieved. The world’s central banks have now changed track from saving the illiquid debt market to trying to control inflation.

Although the monetary stimulus should eventually revive economic prospects, we expect inflationary pressures to build. The deflation that has come out of Asia for the last decade has often been misinterpreted as something of a constant. Instead, we are now seeing inflation which is being imported from these countries with import prices in the US rising by 15.4 per cent (well above the 9.2 per cent that can be explained by the US dollar depreciation and the highest number since records began in 1983)*. The number of countries in the world which have higher inflation than 3 months ago at the end of March was 83 per cent* and central banks appear, in the main, to be behind the inflation curve.

Inflation is no longer just an issue of a few mismanaged economies but an issue for the global economy. In our view at HSBC Private Bank, there are a number of factors behind this but the four most important ones are: commodity demand, tightening capacity constraints, strong domestic demand in emerging markets and currency appreciation. HSBC Private Bank’s view is that, those countries with strong fiscal tightening policies should end up better off than countries which have no policies or choose not to increase interest rates due to political unpopularity.

Asian Banks are facing the difficult dilemma of trying to restrain inflation while not derailing economic growth, most notably Indonesia, the Philippines and Vietnam. Apart from the danger of social unrest from these tightening policies, they also severely limit a company’s ability to borrow and hence the potential to grow earnings.

There are, however, industry sectors that appear much more resilient to these testing conditions than others; one would expect the financially stable sectors such as telecoms and utilities to shine but the reality, according to our analysis, suggests something different. Tracking sector performance following inflationary shock periods shows that telecoms and utilities tend to trail while energy tends to show the strongest performance. *Source Thomson Datastream July 2008.
Organisation for Economic Co-operation and Development (OECD) leading indicators appear to have peaked.
Source: O.E.C.D. as of 2nd July 2008.

Global credit tightening and the destablisation in investor confidence continues to impact global property with the most marked adjustments being felt in more mature markets like the US, UK and Japan. As book values decline and lending criteria increase it is anticipated that an increasing number of leveraged investors could breach their mortgage covenants which could lead to distressed selling. In HSBC Private Bank we believe most value in real estate markets can be found by following more positive macro economic trends, such as urbanisation and expanding middle classes in emerging markets. Primarily, this view is based on the strong fundamental of Asian real estate markets but also the relatively stronger consumer outlook in these markets. Similarly, rent growth remains robust in Russia, Turkey and Brazil. To us, this implies a dichotomy of depressed sentiment in western markets and long term opportunities in emerging markets; on balance we prefer a neutral with a negative bias position to real estate markets.
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Commodities markets are also offering interesting investment opportunities. The flight to quality mentioned earlier is seeing a rise in demand for precious metals. While demand for industrial metals remains strong they do present a more volatile prospect. With demand being sustained largely by the ongoing expansion of Asian economies questions must be asked if this growth can be sustained in the face of further economic downturn in G7 economies. Again, in-depth expertise is required before taking positions in these areas. In our view in HSBC Private Bank, despite the upward momentum exhibited by oil of late, it appears that supply and demand fundamentals are pointing to weaker oil on the horizon, although liquidity pressures remain on the upside. Away from the energy complex, we continue to see strength in agricultural commodities, with consistent demand from emerging markets, as well as long term strength from precious metals. Given the weakening outlook for global growth, we believe the outlook for industrial metals remains muted.

Looking more towards the mainstream again good defensive stocks at present tend to lie in the food and agri areas which are benefiting from the twin forces of population growth and increased demand for biofuels.

Currencies also remain an area for generating funds in more turbulent markets. Forecasts for more sharply pronounced downturns in the UK and Eurozone economies, if they come to pass, will underpin the relative strength of the US dollar. There also remain opportunities in currencies of developing economies. Steady appreciation of the Chinese Yaun is one worth noting.
These are all areas where there are attractive returns to be made even in the current climate.

The main risks to the global economy still resides with inflation and the end game for the global credit crunch and how wide it spreads. A few poorly performing companies in the stock mix and a reversal of fortunes for China or India and the returns could quickly plunge into the red.

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