By GRAHAM FROST 19/05/2006
The stockmarket’s three year bull-run derailed this week, with the FTSE 100 falling over 6% since last Friday, 12 May.
This appears to be in reaction to growing concerns that rising global interest rates and inflation could cause a slowdown. US core CPI inflation has risen by 0.3% in each of the last two months and now stands at 2.3%, above the Fed’s comfort zone of 1-2%. Rising inflation will heap further pressure on the new Fed Chairman, Ben Bernanke, to continue raising interest rates. The outlook is made worse by the extent of the US trade deficit. While a weakened Dollar may help alleviate the deficit (thanks to making US exports more competitive) it will put renewed pressure on the Chinese Government to revalue the Renminbi, which could signal the end of ultra-cheap Chinese imports and deal a further blow to inflation.
| "This is no repeat of the dot.com era." |
However, this is no repeat of the dot.com era. Companies are generally in good health and equities still look reasonable value versus gilts. Provided that the inflationary pressures now emerging can be controlled without raising interest rates substantially, the falls might signal no more than a correction. However, the dangers of high inflation and a big trade deficit have become highly visible to Icelanders this week: interest rates have been raised to 12.25%.
If there’s one positive to come out of this week, it’s that the market falls have acted as a much needed wake-up call to keep soaring investor euphoria in check.
Investor euphoria is a concern. During three years when just about every asset type has performed well, it’s been easy for investors to be lulled into a false sense of security and take on more risk than is sensible. Booming stockmarket and natural resources fund sales suggest this has been the case: IMA net retail fund sales during Q1 2006 were £4.57 billion, not far off Q1 2000 at £5.42 billion and a major upturn from £1.31 billion during Q1 2005.
If you haven’t done so recently, now would be an opportune time to review your portfolio and ensure it is well placed to cope with any further market turbulence moving forwards. As per our recent article, if healthy profits (or over-enthusiasm) have tipped you overweight in equities or natural resources then re-balancing your portfolio will help avoid excessive risk.
As a reminder, balancing your portfolio means holding a wide range of assets which have little, if any, correlation to stockmarkets. As the list below shows, corporate bonds, commercial property, commodities and hedge funds are useful in this respect.
Correlation to FTSE All Share Index over the last 10 years
(100% = near perfect positive correlation, 0% = zero correlation, i.e. totally independent)
IMA UK Corporate Bond sector (investment grade bonds): +13%
IMA UK Other Bond sector (high yield bonds): +55%
IPD UK All Property Index (commercial property): +17%
HSBC JC Global Mining Index (commodities): +62%
CSFB Tremont Hedge Fund Index: +52%
| "This week has been the first acid test for many hedge funds." |
Interestingly, this week has been the first acid test for the many hedge funds launched during the last three years. In general these funds have fallen, but by somewhat less than the market. While the general lack of positive (i.e. absolute) returns might surprise some, it ties in with the longer term correlation figure above.
Bestinvest clients can review their portfolios by logging into the Client Centre. Non-clients can use our free Portfolio Healthcheck.