Through rocky landscapes

Angela Merkel must be feeling a little like the captain on the ill fated Costa Concordia at the moment. While at the helm of the euro “dream liner” she thought she was sailing to apparently calm waters. Following the S&P downgrade of many European nations last Friday, her rescue plan crisis has hit a rock. A rock that she knew was there but possibly hoped to avoid. The ensuing panic showed that that the policies announced in the December summit were not sufficient to deal with the problem.

On the balance of probabilities the break-up of the eurozone looks unlikely- David Curmi

Policymakers have continuously failed to provide clear and compelling solutions that the market has confidence in. Fortunately for the passengers of the Costa Concordia, the liner was sailing close to shore and evacuation, though chaotic, was relatively straight forward. For us European passengers though, the euro “dream liner” is not in shallow waters.

Yet policymakers expressed surprise and some degree of annoyance that S&P followed through on its previous announcement that it will review its ratings post the December summit, with a view to downgrading the credit rating of many European nations debt. No doubt we will see more references to the need to regulate and control rating agencies more. This is short sighted, irrelevant and will not solve the problem. Unfortunately, the simple fact remains that governments have, in most cases, not acted responsibly in the way they finance their spending. They got hooked on the drug called “cheap money” and now need to rehabilitate themselves. A process that is always painful.

Where does this leave us from an investment perspective? Unfortunately, the number of safe havens to run to is diminishing fast. There are some real concerns out there which, without a change in mind-sight are difficult to address. Take for example the concept of low interest rates. Investors searching for yield need to come to terms with the fact that, in today’s world, buying high quality investments means obtaining yields of between three and four per cent, sometimes even less. Local government bonds are always going to be an option for a domestic investor, as is the local banking sector. But even here one needs to be prudent in approach. I would certainly not advocate putting all my eggs in one basket, even if that basket is the Malta government.

Nor would I necessarily feel comfortable with all the bank deposits on offer. The basic premise that the higher the return, the higher the risk, is valid on bank deposits too, irrespective of the deposit guarantee scheme that is in place. Investors need to review the investment landscape and build a portfolio of investments that takes into account modern day risks in the markets.

It is clear that one of the main outcomes from the world debt crisis has been the strength of the non-banking corporate sector. Many such companies are in much better shape to cope with any oncoming storm than governments. It is therefore prudent for investors to build this into their portfolios, both in the form of using bonds issued by high quality companies, preferably not banks, as well as equities with strong, well covered dividends.

According to Morgan Stanley, the average interest cover on European investment grade, non financial bonds remains at a level of 7.5 times whereas on average companies issuing non investment grade bonds (those rated below BBB-) had interest cover of 3.5 times. Whilst both of these are well above the average locally, it is important for investors to pick carefully amongst the many bonds available, as any recession in Europe is likely to hit company profitability to some extent. The key is to identify the stronger more resilient companies with sound balance sheets and lower volatility in earnings. This comes at the cost of forfeiting higher rates of interest but in times like this, capital preservation is paramount.

What of the euro? This remains very much in the eye of the storm. Although on the balance of probabilities, the break-up of the eurozone looks unlikely, it is still a plausible outcome. Investors across Europe are recognising this and the flows out of bank deposits, especially in the peripheral areas continued to gather pace. According to Credit Suisse in the six months to November 2011 deposits in the periphery fell by €100 billion. Much of these went to Germany, but with the euro facing a period of potential weakness, funds have been exiting the currency completely. For a local investor this is problematic as moving out of the euro creates currency risk, but this can be seen as an insurance policy, protecting against the unlikely but somewhat devastating effect of a Euro break up.

Building a defensive strategy is still the preferred option at the moment and not too late to do this.

Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

www.curmiandpartners.com

Mr Curmi is managing director of Curmi and Partners Ltd.