Take defensive steps as trust crumbles

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Investors have scaled the stockmarket's "wall of worry" adeptly over the past six months or so - and they were climbing it most swiftly in the first 10 weeks of 2013. However, stamina was waning even before the Cyprus bail-out shock put the skids under the markets.

In the UK, it has been the big companies of the FTSE 100 (UKX) making the running, up 10% this year, reversing the pecking order of 2012, when small and mid-sized companies generated superior gains. Many FTSE 100 constituents make their money overseas, particularly the giant energy and mining companies, and are benefiting from sterling's recent weakness against other major currencies. Last year, however, sterling was relatively strong, dampening overseas earnings.

Our investment trust tips illustrate the extent of the recent bullish mood: our aggressive selections - up an average 27% by early March - have far outstripped the defensive selections since they were tipped last September, with the lion's share of gains coming in the past three months.

For the latest on the trust tips, read: Aggressive investment trust gains call for protection.

However it's advisable for investors to reassess the attractions of the defensive "steady-eddies" and other less risky asset plays. We have highlighted throughout various features in the past few months that we are not yet out of the financial-crisis woods. The €15.8 billion (£13.5 billion) Cyprus bail-out debacle was a stark reminder and also served to remind us how political incompetence can easily stop a stockmarket recovery in its tracks.

Jim Reid, a respected strategist at Deutsche Bank, summed up the shock and disbelief among global investors as this article went to press on Monday 18 March. In a macro-economic strategy note, he says: "After my shoulder operation on Friday, the anaesthetic daze lasted around 24 hours and I had a strange dream that a European country had seized a portion of insured depositors' money to fund a bail-out while senior bondholders of the banks and the sovereign survived unscathed. I think it took until yesterday, and the effects of the medicines to wear off, to realise that this was what actually happened."

Whether or not small savers in Cyprus banks with insured deposits of up to €100,000 are ultimately forced to take the proposed hit of 6.75%, or any hit at all, investors-at-large view the proposed bail-out "tax" as a game-changer. EU policymakers will continue to insist that the bail-out tax is a one-off. Nevertheless, Reid points out that in relation to future bail-outs, this "has surely changed the landscape in Europe and now provides a template that will be at least on the table, even as a bargaining chip only, in the years ahead".

The bail-out terms will further sap the fragile confidence of savers in southern Europe's weak banks - these savers can now count themselves among those being earmarked for private sector involvement (PSI) in future bail-outs. It is extraordinary that policymakers are prepared to risk a run on weak banks. The run on Northern Rock in 2007 is still fresh in our minds, but seemingly not in Brussels or Berlin. As Mervyn King, governor of the Bank of England (BoE), said in the aftermath of Northern Rock, it is not rational to start a bank run but rational to participate in one once it has started.

On the investment outlook, Julian Jessop, chief global economist at consultancy Capital Economics, says valuations of equities remain quite low in many eurozone countries. But he warns: "Concerns about the disastrous financial and economic consequences of bank runs could still weigh on share prices. And the return of fears that Cyprus and other countries may actually leave the eurozone altogether could lead to a sustained correction in the prices of equities more generally, as well as other risky assets."

Giving a higher weighting to government bonds (in anything but the very short term) is not the easy answer to this re-opening of the eurozone's festering wounds. That's because inflation is the real enemy that lurks in the shadows, and as February's higher reading of 2.8% further confirms, it has consistently been above the BoE's 2% target since the end of 2009. Inflation expectations remain elevated and this will have a corrosive effect on non-index-linked bonds that are held for the longer term.

Other safe havens look attractive in the current environment - gold in particular. At just over $1,600 an ounce, it is below the mid-point of its 52-week range of $1,528-$1,794, with $2,000 an ounce targeted by many analysts this year. Exchange traded funds that invest in physical gold and also synthetic gold ETFs that hedge back to sterling, are good ways to get exposure.

I also reiterate the attractions of commercial property: it is a halfway house between equities and bonds, and the income element is generally inflation-protected. Our current favourites include funds such as First State Global Property Securities and Legal & General UK Property; along with investment trusts F&C Commercial Property and Schroder Real Estate.

Finally, among equities, Amit Lodha, manager of the Fidelity Global Real Assets Securities fund, makes a compelling argument for the current environment: "It makes sense for investors to have at least part of their portfolio invested in inflation-resistant assets - real assets that cannot be easily replicated as money can be. While it would be impractical for most of us to buy an airport or a gold mine, it is possible to invest in stocks backed by real assets whose value is less likely to be eroded by inflation."

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