When we hear more and more talk from politicians, fund managers and economists about ‘an uncertain market outlook’ we can certainly expect risk assets such as shares and commodities to fall.

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I’m expecting quite a sizeable fall. I outlined the reasons in November’s Money Observer and in several columns throughout 2011. Many of these reasons are obvious: policymakers are impotent when it comes to preventing contagion in the eurozone, and that’s creating a negative feedback loop into the wider global economy and its growth prospects. The banks that hold eurozone sovereign debt are shutting up shop, other banks won’t lend to them, and the very real prospect of a second credit crunch is closer than we think.

Meanwhile, falling industrial commodity prices reflect the view that all is not as rosy in the world as equity markets would lead us to believe. I’ve been amazed at their resilience. Global markets had their best month for years in October ­– our All-Share index was up 7.9 per cent and more risky regions such as Latin America gained 13.5 per cent. From the mid-August trough to the end of October the equity gains were even higher.

However, in the UK, at least, stock market volumes were not as strong as usual in October – the time when traders gear up for the traditional pre-Christmas rally. So while the FTSE 100 index appeared to be defying gravity, there wasn’t much fuel driving it higher.  

Now, however, I suspect we have reached the tipping point. Equity markets have hitherto focused on the resilience of cheerful corporate earnings – particularly in the US – while choosing to largely ignore the fearful implications for global growth prospects that the eurozone debt crisis engenders.

In a few days we have heard warnings from the likes of HSBC, GM and PSA Peugeot Citroen that the impasse on the eurozone is likely to, or already has, damaged prospects for profits.

Markets have also chosen to focus on the idea that printing yet more money in the US, through a third round of quantitative easing, will go a long way to lubricating the wheels of economic expansionary lubrication rather than seeing it at as the act of an increasingly desperate man. The Federal Reserve’s Ben Bernanke is fast running out of options to kick-start the US economy into anything more than spluttering growth.

Markets have also put far too much faith in the weasel words of leading politicians that they will defend the euro at all costs: what they have done is too little and now it’s almost too late, because it’s increasingly apparent that ‘at all costs’ may not be enough to break the negative feedback loop. As yields on 10-year government bonds issued by Italy exceeded 7 per cent, the level that forced Ireland, Spain, Portugal and Greece to seek bailouts, respected credit analyst Alberto Gallo at RBS was reportedly telling institutional investors: ‘The situation has deteriorated so dramatically that a large-scale asset buying by the European Central Bank would not necessarily be a panacea.’

The problem is that Italy is universally viewed as too big to be bailed out. The answer must lie with the European Central Bank taking on the traditional central bank role as the lender of last resort. It’s clear that the cash-rich emerging nations are not going to cough up the necessary funds until the eurozone nations can do more to help themselves.

But that leads to Germany, which would inevitably have to bankroll the lion’s share of a hugely expanded ECB balance sheet. But Germany doesn’t want that: although it was happy to lend euros to the periphery to buy German goods that the Club Med populace could not afford before they joined the euro party, it doesn’t want to take its share of the pain now that they are bust. Germany wants to have its Black Forest Kuchen and eat it. It can’t.

Until Germany acquiesces and allows the ECB to fire a very big bazooka, the failure to prevent sovereign bond contagion spreading from Greece et al to Italy ratchets up the prospect not only of mass defaults across the eurozone periphery but a break-up of the eurozone itself. With the ECB clearly reluctant to wade in and significantly ramp up its bond purchase programme, Ben May, European economist at Capital Economics, sums up the problem neatly.

‘Italy is now close to being unable to borrow from the financial markets and it is far from clear whether anyone is willing and able to meet its financing needs for more than a few months. Accordingly, there is a clear risk that some form of Italian default could take place, perhaps next year. Even if European policymakers cave in and support Italy, such support may be conditional on some form of private sector involvement.

‘Either way, the likely financial and economic consequences of an Italian debt restructuring would present a major threat to the stability of the currency union and could eventually lead Italy, along with some of the region’s other troubled economies, to leave the eurozone.’

Aside from the inevitable loss of jobs, companies and economic output across the globe as a fearsome credit crunch takes hold, the consequences of a eurozone break-up for investors’ portfolios will be worse than anything most people will have experienced in living memory. Can we trust in our leaders to ensure that it does not? Recent high-level pow-wows do not instill confidence. Whatever the outcome, and it appears terminal for the eurozone unless countries sign up to losing a degree of control over their fiscal destiny, it’s important to remember that any lasting solution to the eurozone conundrum will not solve the entrenched debt problems elsewhere in the developed world. The UK, the US and Japan will still be deep in debt. Tough times clearly lie ahead.

In November’s Money Observer I said wise investors with a short-to-medium term horizon will have used the extraordinary bounce in equities in September/October to reduce exposure to cyclical shares and to top up on quality corporate bonds, gold and commercial property. 

That was when the FTSE 100 was trading around the 5500 mark. Currently its trading around 5400 so it isn’t too late to take some risk off the table if, like me, you believe the stock market glass is looking a lot less than half-empty.

In October I went on record to say that the FTSE 100 will retest the lows of around 4800 before the year is out. The interconnected nature of global markets means other developed equity markets will also fall and more risky emerging markets will be even worse off – witness the 5 per cent overnight drop in Hong Kong and Korea, a market widely seen as a proxy for global growth prospects.

European and UK equities

Graham Secker, European equity strategist at Morgan Stanley, is also firmly in the bear’s camp. In a recent strategy note he gave four reasons to be fearful of share prices following the double-digit rally, which he views as ‘a traditional counter-trend rally in an ongoing secular bear market’:

1 – Policy response not yet sufficient  ‘We do not believe that the ongoing policy response is yet at a level where it can stabilise equity markets. Quantitative easing from the ECB would be the key positive game changer for stocks in our opinion.’

2 – Economic growth deteriorating ‘Key economic indicators suggest that the eurozone economy is slowing with the prospect of additional austerity and bank deleveraging to come. We doubt the recent improvement in US newsflow is sustainable into 2012.’

3 – Corporate margins are falling ‘In addition to weak economic growth, corporate profits are coming under increasing pressure from deteriorating margins.

4 – Market timing indicators now less constructive ‘We have seen a meaningful rise in our key market timing indicators and, although not particularly high, they are no longer in "buy" territory.’

The fourth point needs elaboration: many fund managers have been telling us that European equities are ’cheap’, whereas Secker believes they are anything but that. Across Europe as a whole equities are currently yielding in excess of 4 per cent, which on the face of it looks very attractive when compared with quality government bonds (you get paid just 2 per cent a year to hold US Treasury bonds and German bunds for 10 years) and cash.

Over the past 50 years it’s been rare for shares to yield more than bonds. But prior to the 1960s it was a quite commonplace occurrence. And if we’ve learned anything from the 2008 financial crisis it’s that we should look back further than the 1960s and 1970s for market precedents.

Morgan Stanley is tilting client portfolios towards corporate bonds, which offer a competitive yield compared with equities in a low-growth environment. Secker also favours cash, which might not yield you much, but will afford you the opportunity to step back into the equity markets for bargains.

Secker is preparing for falls of 20 per cent in the coming months because he forecasts that European equities will trade on a single-digit Shiller price/earnings ratio. This measure was developed by Robert Shiller and detailed in his book ‘Irrational Exuberance’ . It’s a cyclically-adjusted p/e over 10 years and tells investors whether shares, or wider markets, are cheap or expensive.  

Brian Dennehy, head of advisory firm Dennehy Weller, adds: ‘European equities may look cheap on a cyclically adjusted p/e ratio over 20 to 30 years. But 30 years is the extent of the European data, and this coincides with a period of time in history where debt was the driver of economic cycles and corporate earnings, so is not representative.

‘Post 2008, debt is more likely to drag than drive. 

If instead you reference the p/e against the long-run UK average then European equities do not look so cheap. Cheap would be at least 20 per cent below current levels.’ 

So with the Shiller p/e of 12.3 for Europe as a whole and 13.5 for the UK, Secker’s single-digit Shiller p/e forecast implies a 20 per cent downside from here, or a level of 4400 for the FTSE 100.

When to change tack

Across other asset classes there is plenty of life left in the 'bullet-proof’ strategy suggested by my colleague Barry Riley in last January’s Money Observer – gold, German bunds and US blue chips. While the FTSE 100 is down 5 per cent on the year (and has been down as much as 16 per cent), the S&P 500 is up 15 per cent in sterling terms, gold is up 44 per cent and the 10-year bund is up 8 per cent.

He will explain in the January 2012 Wealth Creation Guide why at some point in 2012 it could become necessary to change tack – from gold to deposits, from US blue chips to small companies and emerging market equities, and from German bunds to corporate bonds.

Long-term investors, particularly those who are using regular savings schemes, have little reason to change tack. In emerging markets, for example, funds and investment trusts managed by Aberdeen and First State focus almost exclusively on companies with high standards of corporate governance and proven track records. So while those companies’ shares will get trashed in a dash for safety, regular savers can pick up these funds and trusts at knock-down prices.

Multi-asset funds

Investors who are not confident in their ability to time the markets should consider the merits of multi-asset investment strategies.

The table below, courtesy of Trevor Greetham, who manages Fidelity Worldwide’s multi-asset funds, shows how various asset classes perform at different points of the economic cycle. In this instance the period measured is from April 1973 to January 2010.

How asset classes behave in economic cycles:

Multi-asset funds can also tweak their weightings according to the prevailing economic conditions. ‘Weak surveys of business confidence are suggesting the pause in US and global growth could develop into a more worrisome slowdown,’ Greetham says. ‘Policymakers are compounding the issue by tightening fiscal policy in response to market stress. The sensible strategy for many investors will be to retain a diversified portfolio, but one that favours bonds over equities at present.’

The Fidelity Multi Asset Strategic fund has a decent track record, as does Newton Real Return fund. Among investment trusts, RIT Capital Partners and Ruffer Investment Company are worthy multi-asset vehicles, although the shares of both are currently trading on premiums to their net asset value.

Bond funds

Among bonds, there is a strong argument to also invest in funds that take a flexible approach between government bonds, high yield and and investment-grade corporate bonds, and index linked gilts. Three funds that Money Observer likes in this space are Fidelity Strategic Bond and two with a narrower remit – Baring Global Bond, which invests exclusively in government issues, and M&G Strategic Corporate Bond.

The table below shows why a flexible approach can be rewarding if a manager times strategic switches correctly. For example there was a 50 per cent difference between the average performance of fixed interest sectors in 2009: the average UK gilt fund lost 2.7 per cent but the average high-yield bond fund gained 47.9 per cent.

IMA average annual sector returns:

Source: Morningstar Workstation. IMA Sector Average, Basis: Bid-Bid, net income reinvested as at 30/09/2011.

Gold in times of stress

One further word on gold. At $1,784 an ounce, the price has taken a breather since hitting a high of $1,912 on 6 September. Research from the World Gold Council shows that a diversified portfolio of bonds (25 per cent), equities (55 per cent) and cash (5 per cent) that also holds a relatively small proportion of gold – of 4 per cent – helps to increase performance during various ‘tail-risk’ events.

For example, such a portfolio would have outperformed by 5 per cent in the four-month period that culminated in Black Monday in October 1987; by 13 per cent in the global recession between September 2007 and February 2009; and by 157 per cent in the first stage of the sovereign debt crisis between December 2009 and June 2010.

While all bar the last period would still have resulted in an overall loss, the role of gold – if only as a hedge against wider losses – in a diversified portfolio is clear.

The purest way for fund investors to gain access to gold is through an exchange traded fund such as db X-trackers Physical Gold or iShares Physical Gold. Both providers also offer sterling-converted share classes.