By Roy Varghese
Director, financial planning practice,
ipac Singapore

Those working in high-rise buildings can probably relate to this experience. It is noon and you are waiting for the lift on the 27th floor to take you down to street level for lunch.
The lift door opens and it's full of people from higher floors. After waiting 10 minutes, you decide to take the lift UP so you can get DOWN.

Investors in Singapore now face the double whammy of low economic growth and higher-than-average consumer inflation. Everybody is in a hurry to eat lunch, but they are frustrated at how long they have to wait for the lift to carry them to the ground floor.

Staying in cash or fixed-income instruments to catch the market bottom is a tempting proposition. But in the meantime, the 7 per cent inflation rate erodes the purchasing power of capital left in defensive assets. Banks are selling inflation-linked bonds and other capital-protected products. Investors who choose this option will have their cash tied up for three years or more in the hope that equity markets will have recovered by then. Are these tactics appropriate for a long-term investor?

Very few investors are confident-looking at the long term when the media speculates on the price of oil after the next hurricane or the fallout from another bank write-down. A technical recession - two consecutive quarters of negative growth - is still not on the cards as consumers around the world, supported by fiscally prudent governments and leading central banks, continue to buy goods and services from global companies.

Nike is likely to sell more running shoes in China after the Beijing Olympics, and McDonald's will still be in business as long as people can afford a hamburger for lunch. Microsoft will sell software as long as Dell and Intel can find new customers for PCs. On the whole, profit margins may be compromised if rising input costs cannot be passed to customers. But as long as corporate balance sheets are strong and credit is available, investors have good reason to remain as owners of global blue chip companies.

After the recent market corrections, shares are more cheaply priced today. Chart 1 shows that forward price-earnings ratios are lower than their long-term average over the past 10 years, indicating that value has returned to the equity market. Interestingly, emerging market valuations are now similar to those for more developed markets. While it is impossible to predict future short-term trends, international shares, combining OECD and emerging economies, are positioned to deliver returns in line with their long-term average.

A look back in time since the technology bubble in 2000 may give us some clues on how to deal with dull and volatile markets. For three consecutive years from 2000 to 2002, the average return on a global equity portfolio was -10 per cent per annum. Then, from 2003 to end 2007, the average annual return for MSCI World was about 13 per cent per annum. For this entire eight-year period, the average annual return was about 8.6 per cent. In the Singapore context, this represents 5 per cent per annum above the average rate of inflation.

This inflation-adjusted return is very commendable for a moderate-risk long-term investor.
If we make some rough assumptions for the next three years, it is possible to assess the risk of staying invested in a global equity portfolio as opposed to taking cover in cash and bonds. Let's assume that:

Consumer inflation in Singapore will be 7 per cent in 2008, 5 per cent in 2009 and 3 per cent in 2010.

Global equities will deliver -10 per cent in 2008, zero in 2009 and 8 per cent in 2010; and

Fixed income investments will yield 2 per cent per annum over this timeframe.

Chart 2 projects that the outcomes in purchasing power - nominal return less inflation - at the start of 2011 will be about the same for two investors who invest $100,000 at the start of each year from 2008 to 2010. The top line is the target of purchasing power of the three annual investments at the assumed inflation plus 5 per cent per annum.

The main difference is that a strict fixed-income portfolio will have a cap on growth, whereas equities will offer the possibility of a pick up when the recovery phase begins. In a higher-than-average inflationary period, the model portfolio must have the opportunity to work harder than pure defensive assets. No doubt about it: investors face some risk as owners of quality companies, while lenders of capital have to deal with the risk of inflation. Which strategy can take advantage of opportunities when markets recover?

There has been a rapid shift in market sentiment from euphoria in early 2007 to pessimism today in response to the credit crunch and rising energy prices. Share prices reflect short-term fears as opposed to underlying economic and corporate fundamentals. This is what the long-term investor should do to B.E.A.T inflation:

Build an inflation-proof globally diversified portfolio of reasonably priced quality stocks

Embrace market risk

Avoid investment traps that result from being distracted by market noise

Time in the market; not timing the market

Going back to the lift analogy, lunch is over and it's time to go back to work on the 27th floor of your building. Everyone else in the building is in the lobby and you have a long wait to catch the lift up. It may make better sense to avoid the crowd at the ground floor and take the lift DOWN to the basement so you can make your way to the top - a detour that takes courage and wisdom to take, but which may just allow you to reach your destination ahead of the pack.

This article was first published in The Business Times on September 6, 2008.