Financial markets in Canada and the United States are facing a path littered with economic, political and biological pitfalls, and investors looking to protect themselves from the elevated risk should adjust their portfolios, according to a report from RBC Dominion Securities Inc.
“It seems to us that investors have adopted a rather complacent view towards rising macro, political, and biological risks,” said Myles Zyblock, RBC's chief institutional strategist. “We continue to recommend that investors take steps to protect portfolio performance against a re-pricing of risk.”
Some of the steps investors can take include paring their overall equity holdings, lowering their exposure to economically-dependent sectors, and buying larger-capitalization companies, he said.
In the economic realm, central banks around the world — such as Europe and Japan — are eyeing higher interest rates, meaning stocks might soon be operating against a background of co-ordinated global monetary tightening.
Meanwhile, the U.S. current account ballooned to $225-billion (U.S.) in the fourth quarter from $185-billion in the third quarter and the U.S. economy now requires more than $2.2-billion dollars each day from foreigners to make up for its lack of savings, the RBC report said.
At the same time the U.S. is faced with this unprecedented need for external financing, it is also placing increasingly restrictive conditions on those required inflows, RBC said.
The U.S. has done a number of things to anger other countries: pressuring Beijing with regards to yuan, blocking a bid by a Chinese oil company for Unocal, and most recently, attempting to block a Dubai-owned company from managing and operating U.S. ports on the basis that it posed a threat to security.
“Trade frictions and protectionism could be pushing international relationships and the economic balance towards a tipping point,” the RBC report said. “This seemingly benign situation could quickly turn malevolent given the unbalanced nature of the global economy.”
Higher global interest rates would not only gradually slow economic growth, they would also reduce the amount of money available to finance the massive U.S. deficit.
“Rising trade frictions in concert with political retribution, and/or continued deterioration in the U.S. savings rate joined by robust acceleration in domestic demand elsewhere are the foundation for our unease,” the report said.
Aside from economics and politics, stocks are also facing a biological risk in the form of a possible avian flu pandemic, RBC said. Although the World Health Organization says that only 98 people have been killed by bird flu since 2003, it also maintains that if the virus were to mutate so that it was easily transmitted between humans, it could lead to as many 7.4 million deaths and cause “significant social and economic disruption.”
Despite the many risks outlined above, RBC noted that investor optimism for risky assets remains “very high,” with the market volatility index at historical lows, credit spreads heading lower from already depressed levels, and U.S. small-capitalization companies leading the charge higher.
To protect themselves from an “absolute” stock market decline, RBC recommends that investors pare their equity exposure outright, either through the use of options or by lowering their volatility quotient.
Another recommended strategy is to lower valuation risks through buying larger-capitalization companies, the report said. In the last six years, small-cap companies in both Canada and the U.S. have traded at a sizable premium to their large-cap peers.
In terms of specific sectors, RBC recommends cutting out some of the economically-sensitive equity sectors, a move that will “protect portfolios from the general forces of an earnings slowdown and the possibility of increased earnings disappointment.”
In Canada, buy bank, insurance, telecom and industrial companies and avoid energy, consumer discretionary, materials and technology sectors, the report said. In the U.S., RBC has an “overweight” rating on telecom, consumer staple and pharmaceuticals and an “underweight” on materials, financials and consumer discretionary stocks.
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