The unthinkable and the unexpected has happened. Standard and Poor’s (S&P’s) has downgraded the much vaunted AAA credit rating of the US to AA+. World financial markets have witnessed heightened volatility over the past few weeks with the VIX index in the US, the gauge of volatility in stock markets, spiking by 50% in a single trading session on 8 August, the first trading day after the S&P’s action and then correcting by 27% the following day, after the Federal Reserve meeting.
The US is now among a handful of countries that have national debt in excess of 100% of their gross domestic product. A substantial increase in the debt burden of the Western world since the financial crisis has resulted in credit rating downgrade of many countries, including Greece, Spain and Ireland. Europe has been struggling with bailout of beleaguered nations for the past few years. With the US fiscal deficit not showing any signs of meaningful improvement, financial circles have for some time now been murmuring about the possible downgrade in credit rating. However, most analysts did wonder whether the rating agencies would really go ahead with such a strong measure. As such the announcement from S&P was received with a certain amount of disbelief and surprise. Equities and commodities markets reacted violently with sharp downward correction.
Amid this chaos, how does an individual investor make sense of what is happening and how these dramatic developments may potentially affect value of his investments.
The macro picture
It will be important to understand the current dynamics driving the economic and financial markets. Over the last decade, governments and central banks have had an increasing role in ensuring the well-being and positive momentum in financial systems. The world economy has benefited immensely by the heady cocktail of liberal spending (of borrowed money by governments) and central banks (too submissive into cutting interest rates at the first sign of a slowdown). Spending your way out of a slowdown had come to be such a norm that markets look eagerly forward to regulators bailing them out of every excess, sub-prime being the classic example.
Every time the objective has been to protect the interest of small investors and the poor sections of society. Major beneficiaries though of such massive bailout moves seem to have been big banks and institutions as is evident from lack of adequate job creation and frequent slippage in economic growth momentum globally. The question that arises with this rating downgrade is whether the governments will have to restrain themselves from the current operating model of high fiscal deficits, which incidentally is the most likely scenario. In which case, economic activity is bound to suffer in the near to medium term. This, however, will also lay the foundation of more solid and sustainable economic growth prospects. Stated in terms of market movement, this could cause volatility and correction in the near term but will lead to a much more rewarding investment opportunity for long-term investors.
How will investment instruments behave
So how does one translate this macro outlook into a profitable proposition? First, in the immediate term, till the markets stabilize, investors will continue to seek safe havens for parking surplus cash. Gold, silver and other similar asset classes may continue to find favour till there is more certainty. Fixed income instruments of quality companies will continue to attract massive allocations. Commodities such as crude oil with a perception of limited supply will most likely bounce back on uncertainty in currency markets even though there could be an immediate correction on anticipation of demand destruction with expected slowdown in economic activity.
Stock markets may show a weakening or volatile trend for now but will gradually provide excellent opportunities for long-term investors. The differentiating factor would be the ability to pick up stocks of companies that would survive and benefit from the current weakness. Companies with real assets and real business with strong balance sheets may be available at dirt cheap valuation in this chaos. After all, while there is a strong sense of disappointment from stock markets currently, the fact is that markets have fallen just about 20% from their all-time peak. Of that, 10% last month was due to uncertainty. So even if you switched to gold just a month back, your portfolio would be actually up 20%.
What should you do
The million-dollar question is how practical is that? So, the first strategy should be not to panic and despair but look for long-term opportunities. Secondly, it would be important to diversify your portfolio into various asset classes. Thirdly, to follow a gradual approach to investing rather than impulsive investing or disinvesting. Then, to keep adequate liquidity in hand to take advantage of evolving opportunities. And finally, be prepared to rebalance your portfolio periodically with changing economic fundamentals. For example, this year gold has provided excellent returns and may continue to do so till the current turmoil lasts. However, as the world financial system makes further progress towards consolidation and restructuring, good stocks which survive this may be available at dirt cheap prices and so could residential or commercial real estate assets. If one is able to switch out of gold into stocks at the right time, it could make a huge difference in the ultimate retained wealth of the investor. Similarly, a timely entry into short-term income funds from cash or liquid funds would have turned out to be a good strategy. Keep your ears to the ground, invest for the long term based on fundamentals and be ready to rebalance your portfolio as the fundamentals may warrant.
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Mahendra Jajoo is executive director and chief investment officer, fixed income, Pramerica Asset Managers Ltd.