Photo: University of Oregon
The new year is here and everyone is positioning their investment portfolios for a potentially wild ride. Are you ready?Deutsche Bank analysts Tom Joyce and Ram Nayak recently laid out 10 of the biggest risks facing investors in 2012.
Ironically enough, analysts remain so bearish that one of the biggest risks is that the economy actually does well.
Bear or bull, however, Joyce and Nayak tell you how to hedge for the worst case scenario. Be prepared!
Probability: A Greek euro exit and return to the Drachma is not DB's base case, but then again it's not inconceivable.
What would happen: Big haircuts on private sector assets, capital controls, collapse of Greek banking system, run on peripheral European banks
Hedges: Switch from European assets to gold or U.S. Treasuries, long yen or sterling, and long volatility indices
What to watch: In Spain, the private sector and banking system. In Italy, politics and growth.
What would happen: A crisis of confidence would prohibit both countries from accessing cash and threaten both the euro and the global financial system. The European Central Bank would need to 'respond aggressively,' to save the global economy from collapse.
Hedges: Short French and British banks, short Eastern European currencies, long options on CDX.IG
Catalysts: Risks #1 or #2 materialise, fiscal cuts disappoint, or growth underperforms
What would happen: The U.S. bank sector could also be downgraded. Timing is everything to measure the impact.
Hedges: Issuers can win out by pre-funding, investors should be overweight on non-financials and highly rated non-cyclicals.
How it happens: 5-6% growth, which would feel like a recession
What would happen: Global capital markets would be affected by sharp declines in commodity prices, but China's large Forex reserves it could probably stop the fall and stimulate growth.
Hedges: 6-month put option on commodities baskets
Probability: 'Quite possible,' given lack of progress on austerity measures
What would happen: French-German bond spreads may indicate that this risk is already priced in, but this would have negative implications for the European Financial Stability Facility and already mounting funding pressures.
Hedges: Buy French CDS, 'buy best-of-put options'--a put over the equity index that performs best on the period (because equity markets generally go down simultaneously with a macro shock)
Probability: Deleveraging is definite. The only question is by how much.
What would happen: Deleveraging will probably total up to $2 trillion in 18 months, but this could be exacerbated by crisis.
Hedges: Investment in cyclical industries, lower-rated credits and financials, long volatility indices.
Probability: High, particularly if aggressive bank deleveraging (risk #6) materialises.
What would happen: The European banks that provide financing for the big Swiss-based commodity trading houses could cut funding, and commodities prices would fall.
Hedges: European borrowers should seek funding from the U.S., one-year USD puts on Brent
Signs for caution: Traditional safe-haven assets like gold, the Swiss franc, and the yen have all been volatile
Worse still: U.S. Treasuries and bunds have been go-to investments recently, but high debt levels in the U.S. and Germany could change that.
Hedges: Other AAA-rated investments like supranational bonds and gilts.
How it happens: Both public and private sector funding gaps for pensions are out of control, and this could get worse. Rock bottom interest rates are making this worse.
What would happen: Rating agency downgrades, declines in corporate profitability, and funding crises.
Hedges: Puts on equity indices where premium is only paid out when rates rise (the idea is that they don't).
How this is a problem: Betting against the market always carries the risk of being surprised.
What would happen: Europe stabilizes, the global economy grows, and risk asset prices exceed expectations.
Hedges: '10y/20y euro rates payer spreads; long non-conforming mezzanine debt; Short AUD v Long MXP'