Keep Calm and Carry On

During our family vacation in Europe last month, my wife bought a few postcards with the motto “Keep Calm and Carry On” underneath the British royal crest against a burgundy background from a quirky shop in Arundel, a delightful little market town in West Sussex in southern England. They were produced during World War II to be distributed amongst the British population in the event that Hitler managed to invade the UK. As the Luftwaffe failed to win the aerial Battle of Britain in the summer of 1940, the campaign was not actually rolled out, but the postcards have become a tongue in cheek acknowledgement of the British “stiff upper lip”. Meanwhile Winston Churchill wanted to use the slogan “You Can Take One With You” to encourage people to kill the Nazi invaders, but from an investor’s perspective, the official slogan is the more appropriate course of action.

As North American markets approach the close on Tuesday afternoon, August 9th, it seems that the actions of the European Central Bank and the EFSF bailout fund in buying Spanish and Italian government bonds, combined with Ben Bernanke’s promise today that the US Federal Reserve will keep short term interest rates effectively at zero until mid 2013, have stemmed the panic that saw stock markets down 3-8% yesterday. Earlier today, the UK’sFTSE100 Index joined the German DAX and the S&P/TSX Index in “official” bear market territory, i.e. down more than 20%, while the S&P500 in the US was off almost 15% from its 2011 highs. However, the actions by the authorities saw a sharp rebound in markets. Furthermore, the slide has happened with disturbing suddenness, with many indices hitting or approaching highs for the year as recently as the end of June, or early July. While many observers are reluctant to classify the recent sell-off as a true bear market, owing to its speed, several more observant commentators are grouping it with the Crash of 1987, which saw the index down -33.5% in less than 3 months (101 days), the 1990 sell-off caused by the invasion of Kuwait (-19.9% in 87 days), or the Long Term Capital/Asian Crisis of 1998 (-19.3% in only 45 days.

Nonetheless, the damage that has been caused to investor confidence, the credibility of the European authorities and the perceived creditworthiness of the US by the dissension between and within European governments and the downgrade of the USA from AAA to AA+ cannot be undone. Those commentators claiming the fall in US government bond yields in the last few days proves that the downgrade does not matter are failing to recognize that at present, investors are flocking to perceived “safe havens”, which include not merely US Treasuries but also the Swiss Franc, Japanese Yen and gold. The weakness in the US dollar against assets that , rightly or wrongly, are believed to be safe by panicky investors does not bode well for Treasury yields and prices once the dust has settled. Already, US 10 Year Bonds have seen their yields rise from 2.31% to 2.39% today, while the Swiss Franc has risen 5% against the U$. The inevitable arrival of the QE3, the next round of intervention by the Federal Reserve, will reinforce foreign central banks in their determination to diversify their reserves away from US government debt.

In the meantime, investors should continue to rely on blue chip companies with solid balance sheets, some exposure to faster growing emerging economies and good dividends as their major asset. For fixed income, cash is a sensible choice for Canadian investors, and makes sense for U$ and sterling investors as well. Investors requiring higher yields from fixed income should keep exposure to government debt limited to short to medium term bonds or funds and investment grade corporate and floating rate debt, with a small exposure to emerging market debt via a diversified fund, which is higher yielding and better quality than most developed country debt. However, after stock markets falling as far and as fast as they have done in the last few weeks, the instructions on the postcard are a useful reminder that life goes on. While the volatility makes it difficult to stay calm, as long as your investments keep paying you a reasonable return, the reason you are invested in the first place is still relevant.

Leaving your money in the bank will not provide the average investor with a sufficient return and will be eroded by the inflation that the government support of markets will produce. Government bond yields have been driven down to 40 year lows by frightened investors, and there will be many more bonds coming to fund all of the stimulus that economies need to avoid falling back into recession. Only profitable companies that share their wealth with investors through increasing dividends offer the possibility of maintaining the real value of  investors’ incomes in the next decade.

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