By the time you read this the result of the French presidential election will be known, with Franćois Holland emerging as a clear favourite in the opinion polls. Either way, France holds a pivotal position in the Eurozone and there are consequences for investors.
As I have written in previous columns, much of the short-term pressure on European sovereign debt markets has been alleviated by the cheap loans provided to European banks by the European Central Bank. However, the problems have not gone away. There is simply more time to deal with them now. Unfortunately, some politicians seem to be forgetting this and, in due course, investment markets will lose patience again if clear progress is not made.
To date, France has been an influential ally of Germany in its drive to force other European governments down the path of fiscal austerity. That may be about to change as Monsieur Hollande appears to have a very different agenda that, if implemented, could ultimately result in the fragmentation of the Eurozone.
Regardless of the outcome of the election, France is heading for difficult times from an economic perspective. Government borrowing is not under control and already the French state accounts for 56 per cent of French GDP. Furthermore, unemployment is rising and French banks have relatively weak balance sheets.
“ To date, France has been an influential ally of Germany in its drive to force other European governments”
Of course, it is hardly unusual for politicians to toe the popularist line (an electorate does not usually vote for austerity) when campaigning and then behave quite differently once elected. However, Monsieur Hollande would appear to have rather entrenched views that have been long held. His instinct is to preserve government spending at current levels and simply introduce a much higher tax burden for those who are better off and a top income tax rate of 75 per cent has been proposed. It is unlikely that this approach would ultimately raise enough money to change the current trajectory of government debt.
A profligate France will find it difficult to persuade other countries to toe the German line of fiscal austerity. If there is greater resistance to reform, a possible consequence is that financial markets will punish those countries that fail to make adequate progress Such punishment would be delivered in the form of higher interest rates and possibly, an unwillingness to lend. This may sound harsh but most of us would not be prepared to lend money to someone who we believed would not be able to pay it back. Don’t forget that those who lent money to the Greek Government were forced to write off 70 per cent of it.
So, if the downside risks for investment are increasing again in response to a change in the political mood within Europe, it is worth considering what vulnerabilities exist in your investment portfolio.
Many investors consider that investment in a diversified range (usually a fund) of corporate bonds (securitised debt issued by companies) represents an effective way to reduce capital risk. The rationale is that bonds are generally safer than equities (shares) because even in the event of the insolvency of the company, it is likely that bondholders will have a preferential claim on assets in administration.
However, care is needed because not all bond funds are the same. There are many funds that are simply named ‘Corporate Bond’ but the important issue is not the name of the fund but the remit and behaviour of the fund’s manager.
If your investment objective for bonds is to reduce capital volatility within a portfolio, it is important to know that the type of investments typically held by the fund manager will exhibit a low level of volatility, even in distressed circumstances.
A good example of how two very different funds can perform is shown in the chart on these pages, which looks at how two funds performed during the run up and aftermath of the failure of Lehman Brothers. The funds have similar names but had very different investment strategies and consequently, delivered very different outcomes over the specified period.
If you were about to embark on a long and difficult journey in your car, you would check the tyres, oil and coolant levels and make sure you have a full tank of petrol. I would suggest that now is a good time to have your portfolio serviced, to be sure that it is able to deal with the potholes that lie on the road ahead.
“Government borrowing is not under control and already the French state accounts for 56 per cent of French GDP. Furthermore, unemployment is rising and French banks have relatively weak balance sheets”
I should of course remind you that investments have a habit of falling as well as rising in value and investors should seek professional guidance to ensure that they maintain a diversified strategy that reflects the level of risk they can both afford and tolerate.