Five key risks to the global economy in 2012

David Coombs, head of multi asset investments at Rathbones, is confident we are moving toward a real solution in Europe. But he says several risks remain...

Constructing a portfolio in this environment is tougher than it has even been. With so many indicators, contra-indicators, a lack of obvious trends, and traditional safe-havens that, arguably, look over-valued, where does one start?

We believe the current environment has the potential to be as volatile as that of 2011, and macro messages are not so easy to decipher. Investors can muddle through, but tail risks do exist, and it is important to be cognisant of these. Our top-down perspective has identified five key risks looming over the next 12 months:

1 Tensions surrounding Iran and the Straits of Hormuz;
2 A break-up of the euro;
3 The potential for a hard-landing in China;
4 Higher inflation;
5 Serious deflation in Europe.

The risks are certainly more complex and more intricate than in previous years, making such events much harder to call. However, we remain bullish about markets for the months ahead, albeit with a cautious edge, as there are now some indications that the economic environment is improving, particularly in the US. We are therefore increasing our risk positions where appropriate.

Equity allocations

The cornerstone of most ‘balanced’ mandates has to be an allocation to equities, as most investment professionals believe. We are no exception here – equities will outperform, versus other asset classes, over the longer term. Despite the dot com bust, history has generally supported this view.

In our case, equities form approximately 50% of the allocation (in the ‘Beta’ bucket) in the Rathbone Strategic Growth portfolio, and approximately 30% in the Rathbone Total Return portfolio. Given the associated risks, volatility and potential for drawdowns associated with equities, it is important to balance out this allocation with less equity sensitive assets, or lower ‘beta’.

In our growth portfolios, we target a beta of less than 0.4 for alternative strategies, or non-correlated asset classes. We believe hedge funds have a place in a balanced portfolio, and we allocate to uncorrelated strategies such as macro trading, both discretionary and systematic (CTAs – commodity trading advisers), with the BH Macro fund and the Aspect Diversified Trends fund our current preferences.

The latter is a computer-driven model that seeks profits by identifying medium-term trends, and takes long and short positions (despite the misleading name) across equities, interest rates, government bonds, currencies and commodities.

Such managed futures funds continue to be well positioned to take advantage of the current market dislocation.