In previous columns I have been scathing about governments’ inability to deal with the Eurozone crisis. Little wonder the markets are volatile. But volatility can be the investor's friend. It can throw up opportunities, and this is especially so when investment trust discounts widen. After recent setbacks, I therefore added to both portfolios’ UK smaller company trusts. I am looking to add to other holdings on further weakness as the day of reckoning approaches.
Sticking plasters
The plight of over-indebted western economies struggling to generate growth, and a slowing pace of expansion in China, is casting a long shadow over markets. But it is the Eurozone crisis which is causing most uncertainty. The economic news goes from bad to worse. Growth is hard to find. Popular pressure is kicking back against austerity measures.
The euro project was always fatally flawed, for it required fiscal union. Perhaps it is therefore no surprise the eurozone response to the crisis has been woefully inadequate. The numerous summits and initiatives have failed to grasp the central point. Unlike previous recessions, this one is a deleveraging recession - it is the result of excessive debt, not a lack of demand. Governments and consumers alike have failed to live within their means. Sustainable measures are needed to correct this.
Yet austerity is only part of the answer, and on its own can make matters worse. Such belt-tightening leads to a spiral of cuts, recession and more cuts. No wonder, with the ink hardly dry on the new fiscal compact, many countries - including Germany, France and the Netherlands - are already in breach.
Meanwhile, increased loans from the IMF miss the point – the solution to a debt crisis is not simply more debt. The ECB’s €3trln three-year loan to beleaguered banks has bought time. But what Spanish banks in particular need is more capital, not liquidity, to earn their way out of trouble. No amount of moving this high debt around the system, between banks and governments, will conceal or erode its scale.
Governments in general may practise the dark art of financial repression - keeping interest rates artificially low at both the short and long end of the curve - in the hope that a containable amount of inflation will help erode the debt. But, even if successful, this will again only have a marginal effect particularly as devaluation within the eurozone is not available as a further option.
Longer term, the best way of narrowing the gap between what governments earn and spend is through economic growth. The market knows all other measures are simply sticking plasters. But where are the sweeping supply-side reforms needed to foster this? Where is the political will to cut regulation, bureaucracy and taxes - especially for smaller companies - to generate faster growth? The penny has still not dropped.
Market strategy
The consequence is continued market volatility. Sentiment will continue to oscillate between risk-on and risk-off trades. Such volatility will present buying opportunities. Accordingly, during May, I topped up holdings of BlackRock Smaller Companies (BRSC) in the Income portfolio and Herald trust (HRI) in the Growth portfolio. The discount at that point was 20 per cent.
Having retained an element of defensiveness of late within both portfolios relative to benchmarks, I expect to add to other 'risky' holdings as markets weaken further - if necessary, sourcing the funding from more defensive positions. One can seldom pick the bottom, so it is advisable to buy on dips when you think you are near. Sentiment generally is very negative. The dotcom bust, the housing crash, the banking and eurozone crisis have all taken their toll. Investors have run to the hills. This is when bear markets end.
I do not buy the political mantra that Armageddon will follow if we do not save the euro. This economic claptrap is orchestrated by those still clinging to political union. There have been over 80 cases since World War Two when currency blocs have fractured or broken up. In the vast majority, those countries involved have benefited - I struggle to think of an exception. Meanwhile, the 1997 Asian crisis showed that government bond default does not have to be the end of the world. Asian GDP was higher three years after the crisis.
Following the euro breakup, we will still want to buy German cars, French wine and Greek holidays - the latter perhaps 25 per cent cheaper after exiting the euro. And despite the slowdown in China, focus will then shift to the opportunities presented by a host of positive investment trends and the faster growing parts of the global economy. We are spoilt for choice.
Meanwhile, many markets are beginning to look cheap - particularly Europe. Sentiment trails fundamentals. Now is the time to start buying.
MGHi
Finally, in May I switched the Income portfolios' holding of the gold ETF (LBUL) into M&G High Income trust income shares (MGHi). I’ll explain why in next month's column.
