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Spread the risk

For many investors, the recent volatility in the markets has been a wake-up call. We all know that equity markets can fall as well as rise but the extended bull market that we have seen in equities since 2001-02 has lulled many investors into a false sense of security.

Investors must look to diversify their portfolios. It is important to spread the risk. That way, if equity markets deliver poor performance, the effects of this will be mitigated by better performance from other areas such as fixed income, cash or alternatives.

A co-ordinated package to rescue the financial system is now in place but this does not mean we will avoid a recession. The good news is that inflationary pressures should get squeezed out of the system in the short term. The bad news is there will be a reckoning and perhaps the only way to tackle the debt accumulated by national governments will be to allow inflation to move higher.

In times of uncertainty, government bonds benefit from their “safe-haven” status. With inflation likely to fall in the short term, we believe government bond markets offer reasonable value. The sharp reduction in investor risk appetite has left parts of the credit and emerging debt markets at very attractive valuations.

We are positive on A-rated corporate bonds, where the yield has increased dramatically and offers compelling value. Looking ahead, conventional bonds are unlikely to offer much protection against higher inflation but this is not the case for inflation-protected government bonds. These have suffered recently and now look attractively valued. A modest allocation here would be sensible for investors looking to protect a portfolio against inflation.

The situation is more complex in terms of equities. As we enter a recession, we expect earnings to come under pressure. However, with share price valuations at multi-year lows, investors prepared to take a medium to long-term view could find some attractive investment opportunities.

We still favour the emerging markets, where econ- omies are likely to grow faster than those in the developed world. Countries with a sound external position, healthy economic growth and credible monetary and fiscal policy have scope to stimulate growth now and tackle inflation in the future. In this group comes the resource-rich Middle East and Russia, as well as Brazil and Peru in Latin America.

We also believe in the long-term case for Asia. Growth may be slower but we are confident that China will continue to industrialise, creating an environment where corporate earnings grow at a healthy rate. Given their potential to stimulate growth through infrstructure spending, some Asian economies are likely to come through this challenging climate in a much stronger position than the West.

Property has been a sensible choice for investors concerned about the prospect of rising inflation. However, with the effects of the credit crunch spreading and US and UK property markets falling, investors may want to be cautious about this asset class.

A modest allocation to hedge funds or funds of hedge funds can be an effective way of diversifying investment risks in your portfolio. Investing in commodity funds, along with investments in timber, is a specialist area but, again, for investors with large sums to allocate, this can be an excellent way of diversifying returns and protecting against inflation.

Finally, currency management can offer diversified returns. There are many investment products, which generate a big part of their returns from currency management. Including exposure to one of these strategies can be a prudent move for investors who want to have a source of investment returns, which has a low correlation with traditional equity and fixed- income markets.

Ian Pascal is marketing director at Baring Asset Management

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