Years of cheap credit, with interest rates almost nothing in nominal terms and negative in real (inflation-adjusted) terms, have stimulated a global financial bubble of enormous proportions.
Yet there is now risk of some kind of financial crisis within the next 12 months, which would be a major shock to business and consumer confidence – and to the values of all except the most conservative investment assets, such as cash, gold and government bonds.
As an example, in the US, consumers are so heavily in debt that they are starting to lose their enthusiasm for taking on more. And rising interest rates are making it harder for them to finance what they already owe.
Managers of pension, insurance and trust funds, as well as banks, hedge funds and wealthy individual speculators, have also been using cheap credit to buy exposure to risk in various forms, in their hunt for higher returns. One example of the extremes to which this has been taken, according to CLSA’s Christopher Wood, is “highly leveraged funds-of-funds invested in highly leveraged hedge funds.”
No one knows how large the financial bubble has become, nor how risky it is, as so many of the transactions involved are beyond the purview of regulators.
It would only take one unexpected event, such as a terrorist act, natural disaster or business shock (a fraud or bankruptcy involving a major group) to trigger a crisis that bursts the financial bubble, as those exposed to risk seek to unwind their positions or are forced to raise capital to cover them.
What conclusions should you draw from this increasingly threatening environment for your personal investment strategy?
– Raise the cash in your portfolio relative to your equity holdings. Possibly raise your gold holding, too, as the metal now looks cheap.
– Get out of, or at least reduce, your equity holdings in the most dangerous sectors such as finance, technology, media, and many of the cyclical industries. However gold mining should gain, while oil and natural gas and other sectors being sustained by China’s demand should be resilient in the downturn.
– Shift from high-yield corporate and emerging-market bonds into lower-yield stuff, such as the government securities of major nations, particularly euro-denominated ones.
– Use the next six months to research and prepare for major re-entry into equities. The best sectors to move into for the next major rally will probably be Asia and natural resources (especially energy).
The timing signal to watch for will be the first indication that the Fed is going to stop raising interest rates, and is about to resume its policy of pumping out abundant cheap credit.
By Martin Spring in On Target, a private newsletter on global strateg