Regular readers will be aware of my concerns about the outlook for Western economies (read my previous column Go high and go deep). An extended period of economic flatlining together with other headwinds will continue to make it difficult for markets to make any significant progress. Investors must position their portfolios accordingly. To this end, during October, I added to both portfolios' existing positions in UK blue-chips and Japan.
The investment strategy
This recession is different. Previous recessions have been 'destocking' events, when falling demand has been the main problem. In such circumstances, stimulus packages can do the trick. But this recession has been brought on by governments and consumers taking on too much debt. Indeed, the last Labour government took on more debt than all the previous governments combined – the national debt more than doubled. This is a 'deleveraging' recession, which requires the debt to be reduced, otherwise markets will lose faith.
In trying to reduce debt, governments essentially have just two options in the short term. The first is to cut back on spending; you cannot borrow your way out of debt. The second is to create some inflation in order to inflate the debt away, which is what governments are doing by keeping interest rates at both the short and long end artificially low. In the longer term, economic growth is the best answer but, with everyone trying to reduce their debts, that's hard to come by.
My growth and income portfolios therefore both pursue a policy of 'go high, go deep and go east'. Go deep in that smaller companies – whether here or abroad – will continue to be able to outperform their larger rivals almost regardless of the economic backdrop. This is because many smaller companies now generate a far higher proportion of their earnings from overseas, and have exposure to a wider selection of sectors, than has been the case previously. Go east for superior growth rates at attractive ratings and better fundamentals.
Go high in that good-quality high-yielding equities and higher-yielding corporate bonds should perform relatively well in this harsh climate: bonds because in a higher inflation environment, the higher yield will be more resilient; equities because the high-yielding blue-chips are cheap compared with the wider market at the moment, and because we tend to forget the importance of dividends when it comes to portfolio returns over the longer term.
The latest Equity Gilt Study from Barclays Capital reminds us of the importance of reinvesting dividends. One hundred pounds invested in UK stocks at the end of 1899 would now be worth £180 in real terms without dividends reinvested. With reinvestment, the final figure would be £24,133. Had the £100 been invested in 1945, the resulting two figures would have been £255 and £4,370, respectively. I suggest dividends will assume even greater importance in the current low-growth environment.
Meanwhile, many large blue-chip stocks that offer dependable growth together with decent and growing yield are cheap relative to the wider market. This is not how it should be. Dependability usually equates to quality, and quality usually deserves a premium.
With deleveraging set to continue for quite a while, those companies that can increase profits and dividends almost regardless of economic conditions will come to command a premium to the market – especially if the dividend yield is decent to start with. Indeed, many have yields substantially above their corporate bond yields. Furthermore, such companies are cheap compared with historic valuations, not just the current market. In short, sentiment lags behind fundamentals and this provides an excellent opportunity for investors.
