What should you do with your savings in 2011?

Investment strategies for 2011

What should investors do now?

DISCLAIMER - I am not an investment advisor and these comments are purely my personal opinions and not intended to be taken as guidance on particular investment decisions. Do your own research on particular investments and strategies; do not buy or sell based on my generalised remarks.

A modest recovery isn't making investing any easier

There are not many appetising places to park your money these days particularly if, like me, you are pessimistic about the prospects for a meaningful recovery in the West. Without confidence in a return to strong economic growth, neither of the usual long term investment choices, shares and bonds, hold out much hope of a decent inflation-adjusted return.

Economic growth may be back but there are plenty of reasons to be fearful. One suspects that governments and banks have covered up the financial crisis that preceded the recession rather than resolved it - like matron sticking a plaster on a boil rather than lancing it. Worse, we owe what recovery we do have to incredibly loose monetary conditions and massive increases in government debt, which are likely to create new crises down the road.

Although I can see a recovery of sorts continuing through next year and I don't think a renewed global crisis is imminent, I think one of two scenarios is highly likely looking beyond the next 12 months:

1) Stagflation - the rises we have already seen in commodity prices spreads to general inflation even with high unemployment and low growth

2) Crisis MkII- the excessive debt levels that underlay the 2008/9 crisis have been diffused and spread around but have not gone away. A return to financial crisis could be just a government or bank default away along with a return to deflationary bust conditions we have just emerged from. Some say a China crash could be on the cards which would almost certainly drag us all back to depression type conditions.

Either way, surveying the options available to the average Western investor does not inspire much confidence.

A quick survey of the options

Let's look at some investing themes:

Equities - shares, particularly US ones, would have been a good choice in the immediate aftermath of the crisis but are no longer exactly cheap having climbed for almost two years. Company profits have bounced back well generally but will be tested by austerity measures and rising commodity prices in 2011. Longer term, history suggests that either of my scenarios would be bad for shares.

Government bonds - Apart from Greece and a few other countries, government bond prices have risen over the last couple of years up until very recently. Much of this has been artificially induced by governments buying their own bonds however and the limits of low yields / high prices are being sorely tested now. Doubts about governments' abilities to repay debt are not confined to the likes of Ireland. For all the talk of austerity Britain's deficit is barely budging and the US is bringing in measures which will actually increase the deficit. Long term I have no doubt that most Western governments will default on the debts in one way or another and before then investors will start dumping bonds. Very little upside in government bonds then, although there might be a short-lived 'flight to safety' rally in some governments' bonds in a financial crisis. High quality corporate bonds might fare a little better but they too have got a lot more expensive over the last year or so. Stagflation would be awful for all types of fixed income assets.

Gold - Up more than 500% in ten years and it's not hard to see why. Tends to perform well when there is a fear of inflation AND during a deflationary crash. Ultimately I think gold, even at 1300-1400$ an oz, will pay off because it has unique safe haven properties when governments loose control of their finances and currencies. However 2011 could be risky for gold - it's a crowded bandwagon and a rise in interest rates could cause a rapid change in sentiment. Gold thrives, as now, when real inflation-adjusted interest rates are negative and this is likely to persist for some time but if recovery prospects brighten in 2011 and investors start to believe interest rates will rise there could be a gold price correction.

Emerging markets - A hot favourite of investors in 2010 which itself should give pause for thought - do you want to join the rush just as it all turns sour? Already China and Brazilian equity markets have actually fallen. My feeling is that the Emerging Markets boom has been over inflated by loose Western monetary policy leaking abroad. China is tightening in the face of increased inflation - a hard landing there could turn things very nasty. I believe a China crash will come within a few years but not in 2011. Nevertheless - Emerging Markets risks outweigh the benefits at this stage.

Property - hard to generalise but this a sector which (as we have seen) does badly under the crisis/deflation scenario and may not be such a great place if the alternative - inflation - takes hold and interest rates rise. Cast your mind back to when base rates were 5%, never mind 8 or 15%. Do you think today's property market could bear a sharp rise in rates? The alternative scenario of further bank turmoil and financial crisis would keep rates low but also cause confidence, employment and credit availability to dive which would be bad for property.

Currencies - some investors are being drawn to "investments" in currency trading funds. Currency trading is purely speculative - the winners (and the brokers) will do well but investors as a whole can only lose after commissions are taken out. Besides there are serious question marks over all the major currencies (dollar, pound, yen, euro) and it's a tough call to say which has the riskiest outlook. In recent years commodity currencies like Australian dollar have been a good "China play" but even that trend may be bucked in 2011 if China bears are to be believed.

Cash - the default position if you are unimpressed with any of the above is to leave your money on deposit, preferably with a government guarantee on the account. While savings rates remain pitifully low at least you don't lose capital. Err, but of course you do when inflation takes off. Deposit holders in 1970s Britain saw the real value of their savings plummet in a few years as interest rates went up more slowly than inflation (the classic stagflation scenario). And it wouldn't take inflation of 15-20% to do it. Imagine a savings account earning 2% (after tax). Then picture inflation going from its current 4% to 6 -7% and staying there for a few years. You can see a quarter of your capital disappearing by stealth. Cash would be the right call in the deflationary / crisis scenario which would keep a lid on inflation but will see your savings quickly eroded in real terms if today's combination of rock bottom rates and rising inflation persists.

Horses for courses

So what should you do with your money?

I think the little survey above illustrates how little confidence I have in any of the usual investment choices; none look that great. Even the usually low risk options of government bonds and bank deposits look riskier than usual, particularly in the UK where interest rates are rock bottom but inflation is high and rising. Investors will want to position themselves depending on their view of the economic outlook. Here are some examples of strategies shaped by particular opinions:

- Those who believe more financial crisis and deflation are on the cards should probably be happy to keep their cash on deposit or in bonds but will want to be sure that their capital is completely guaranteed (not so easy to achieve in this interconnected world) Most likely they would plump for bank accounts covered by government guarantees or perhaps high quality corporate bonds.

- Anyone who thinks a decent recovery will take hold in the West with some of the debt problems receding, should be prepared for a rise in interest rates and perhaps a sooner than expected return to positive inflation-adjusted interest rates. This is one scenario that would be fatal for gold. It might be also be bad for shares and bonds, at least in the short term as the markets adjust to tighter monetary conditions. Holding cash on deposit to take advantage of rising interest rates would then appeal - if share and bond prices did fall then you could gradually buy your way back into the market later on at lower prices.

- If you think the recent trend of Western stagnation and emerging markets boom is here to stay, then obviously more emerging markets exposure makes sense. Be careful though as booming economies don't always translate into stellar stock market returns. Another way to play this theme (which I think has mostly run its course) is to buy into commodity exposure - oil companies, miners etc

- if you envisage a faltering recovery but a growing problem from inflation then, as we have discussed, leaving cash on deposit would be a sure way to lose real value. The problem is that bonds and shares would probably also suffer as interest rates start to climb (at least in nominal terms). A big bet on gold is one possibility but it would be a brave call after the run up in the gold price in recent years. Some commodities exposure would make theoretical sense in this scenario - provided emerging markets kept up their growth and demand for inputs. But again prices are already high and there is that nagging fear of a China crash.

Conclusion - my plans

Apart from one or two share buys I have kept my savings on deposit over the last few years. I have missed out on a big rally in share prices and some surprisingly good times for most bond categories since Spring 2009. I wasn't expecting governments around the world to act as they did after the financial crisis. All the quantitative easing and government borrowing has been quite unprecedented and with hindsight was bound to force some asset prices back up and a patchy recovery. Now I expect the recovery to continue, albeit unevenly, but with inflation an increasing problem. That makes me worried that just leaving cash on deposit is no longer an option. Inflation will erode its value and governments will not put up interest rates to compensate - they will choose inflation over deflation.

My preferred solution is to buy defensive shares - preferably in big, well -capitalised companies paying reasonable dividends supported by steady profits that it can keep on generating despite a sluggish economy and inflation. The aim is to find companies who have pricing power - the ability to raise their prices and protect their margins as their input costs rise. Easier said than done but a few sectors have a reputation for doing that - utility companies (often allowed by their regulators to raise prices more than inflation), supermarkets (everyone has to shop) and energy companies for example. Maybe some insurance companies, mobile operators, tobacco giants, pharmaceutical companies and brewers. One thing to be careful of is companies with heavy debt burdens on their balance sheet because however solid their profits are they will suffer with rising interest rates.

In a UK context I might be looking at shares like National Grid, Aviva, Tescos, Vodafone, United Utilities, Admiral, Morrisons, Shell, Glaxo, Centrica.

Will it work? As the name suggests - "defensive" - I am not looking for this strategy to make a fortune. All shares tend to suffer when interest rates rise and no company is immune when one of those giant global economic earthquakes occur as they easily could (Euro break-up? China crash? US Treasury downgrade?). I am not expecting stock markets to do well in the next few years. On the other hand I am not prepared to just sit and watch my savings on deposit decline year after year in real terms. All these companies should still be around making money and paying dividends for the foreseeable future and at least have a good chance of keeping up with inflation. Yes prices might go down in the short term but as long as you are not forced to sell your shares then you can wait until better days when your portfolio's capacity to earn money is properly valued once again.

For a professional investor´s view of the 2011 outlook you could do worse than read this interview with US fund manager Paul Frank Bullish on Small Caps and Betting Against Treasuries

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