Secrets of Success: We're getting closer to the big unknown

Michael Hughes, the chief investment officer at Baring Asset Management, is well known in the City, having for many years been market strategist at BZW in its various incarnations. He had some particularly interesting things to say about the current investment climate when we spoke recently.

Michael Hughes, the chief investment officer at Baring Asset Management, is well known in the City, having for many years been market strategist at BZW in its various incarnations. He had some particularly interesting things to say about the current investment climate when we spoke recently.

His starting point was the observation that investors in today's market are "being made, not paid, to take risk". In other words, with interest rates having been kept so low for so long, and few asset classes looking particularly cheap, investors feel they have no choice but to put their money where they might not normally do so, in their search for returns.

The evidence that this is what is happening can be seen all around the markets at the moment. One obvious example is the difference, or "spread", between the yields on government bonds and corporate bonds. Until a couple of weeks ago, when the markets had their first mini-panic of the year, the spread had fallen to very low levels by historical standards. It is hard to argue that corporate bonds are accurately priced at these levels, or that the yields adequately reflect the risks.

This may be one reason for the second theme Hughes observes, which is the increasing demand for investments that offer some kind of "absolute return" - that is, which offer investors a high degree of security that their capital will not be lost.

Hedge funds are the most obvious example of this trend, but so-called "structured products" (which use derivatives to offer investors varying degrees of capital guarantees) are proving just as popular.

Like me, Hughes thinks that structured products are not a particularly healthy development. Most are, in effect, insurance policies for your capital for which, in his words, "you are paying a very high premium indeed". He thinks that many of those who put their money into these products will come to regret the fact if the markets turn down once more.

It is not impossible, he says, that structured products could in a few years' time become the "next split capital problem". (This, to my mind, also neatly illustrates the general problem that regulators face when you have a product that the industry is mad keen to sell because it is so profitable and that even quite sophisticated investors think is the answer to all their needs. The result: two sets of consenting adults hellbent on causing each other grief.)

This might not matter so much if you could be more confident about the direction that markets may take in the next few years, but Hughes, I have to report, is not particularly sanguine on this score. Three years ago, when the bear market was well into its stride, he was arguing that, on a long historical view, the markets still seemed to him to be behaving more "like 1968 than 1972".

That is to say, for those whose memories are not so long, the market peak that we saw in 2000 might not be the last one, but only the penultimate one in the historical cycle. That's what 1968 - a year when go-go investing was all the rage, hedge funds were proliferating in all directions in the United States, and bull market fever was at its height - proved to be.

If you look at the broader market indices, and the performance of smaller cap stocks in particular, rather than at the large cap indices or Nasdaq, they have all recently touched (or come close to) their all-time highs, so this is still a defensible argument.

But there is another big change in the investment climate coming, Hughes believes. It could mark as seismic a shift in the investment climate as the ending of fixed exchange rates in 1971 (which led to the globalisation of markets and economies) and former chairman of the Federal Reserve Paul Volcker's painful but successful assault on inflation in 1981. That last change, says Hughes, made it "worthwhile for investors to seek out risk" for the first time in many years and ushered in the great bull market of the next 20 years.

The next big change that is coming, however, will be the point at which the debt cycle in the US finally turns. Debt as a proportion of GDP has grown so strongly in recent years that it is as high as it was at the height of the boom in 1929. Although Hughes is not bold enough to say exactly when the cycle will turn, it cannot, he says, be far away. Investors need to be ready for that eventuality.

The big unknown is whether the process of readjustment will result in renewed inflation, or rather deflation, a period of falling prices. Although the threat of deflation appears to have receded, the outcome is, in Hughes's judgement, still an open one. It could yet go either way, and that will have an important influence on how investors need to prepare.

In general, his prescription is that investors will probably do best to look in the direction of index-linked bonds, equity income funds and global funds. With index-linked bonds, which also look quite expensive in valuation terms, he cautions that the UK versions do not, as many other countries' equivalents do, provide price change protection if inflation were to fall below 0 per cent. This is something he thinks the Government should put right as a matter of urgency.

My own take on this is that while we may well be entering the traditional mid-year dull period in markets, there are probably still returns to be made from riskier assets in the next year or so. But Hughes is surely right that the search for absolute returns will remain a powerful theme. The challenge for the financial services industry is to come up with products that meet this demand without (as many structured products do) bringing other still unseen risks in their wake.

jd@intelligent-investor.co.uk