Why your portfolio should be braced for another crash
By
MoneyWeek Editor
John Stepek Nov 03, 2009
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Investors are getting nervous
What's spooking the markets?
The Reserve Bank of Australia jacked up interest rates again this morning.
The move - a quarter point hike to 3.5% - had been widely expected. And the tone of the accompanying statement from Reserve Bank governor Glenn Stevens suggested that further rate hikes will be slow in coming. Traders even reduced their bets on further hikes.
Yet, even though this move should have been "priced in", markets still don't seem to have liked it much. Stocks across Europe are down sharply today. Why?
What's spooking the markets?
The spectre of tighter global monetary policy is starting to worry investors. This week, the jitters are probably particularly bad because we have a series of key central bank meetings in the US, Britain and Europe. We'll discover if the Bank of England plans to extend quantitative easing on Thursday, while the results of the Federal Reserve's latest meeting will be announced on Wednesday.
There's every chance that Western central banks will do nothing. There may not be the vaguest hint of tightening policy, and in fact, the Bank of England might even extend quantitative easing. However, as investors watch other economies around the world tentatively start to recover, they'll start to wonder: "When is all this stimulus going to work? And how will we know?"
The worry is that if genuine growth picks up, central banks will tighten "too early", and there'll be another crash. But another concern is what will happen if 'stimulus' doesn't seem to be working at all. After all, if the likes of 'cash for clunkers' and quantitative easing can't do anything other than provide the economy with a short-term boost, then the question is: "What do we do next?"
Keep your portfolio in defensive mode
For now, the authorities have been given the benefit of the doubt. After all, markets have shot up. But if we don't start seeing real sustainable growth (which seems unlikely, given that consumers and companies are still not keen to borrow and spend), then there's every chance that investors will start to realise that there's not a great deal holding markets up other than hope and cheap money. And those will only take you so far.
In other words, the central banks are between the devil and the deep blue sea. Either they decide that genuine growth is coming, and start to make noises about 'normalising' policy, and risk frightening investors. Or investors lose faith in their stimulus measures, and markets fall anyway. The chances of walking the tightrope between these two options seem slim to us. That's partly because the state of Western government's balance sheets means they don't have that much room for manoeuvre, but also because central banks – like the rest of us – simply can't be expected to make precisely the right decision at precisely the right time.
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This is one reason why we think it's far better to keep your portfolio in defensive mode. Stocks such as pharmaceuticals, whose products are in fairly constant demand regardless of economic growth, haven't risen anywhere near as far as 'cyclicals', whose growth depends very much on the state of the economy. So if investors start to panic about the growth outlook, or the potential for rising interest rates, defensives shouldn't suffer as badly as other stocks, although they'll probably still take a hit.
The best way to think of gold
We are also fans of gold, as you may have noticed. If asset prices take a tumble, gold is likely to fall with them. After all, when money is free and easy, it goes anywhere that'll have it, including assets such as gold. If there's a rush for the exit for any reason, then investors will probably end up selling out of their most liquid positions first, just as we saw during the 2008 crash.
But that's a short-term concern. We can't be sure right now, but the most likely response of Western governments to another pile-up in the markets, would be to try to pump yet more money into the economy. Plenty of economists are demanding more stimulus of governments, and it remains the path of least resistance as far as winning votes goes.
However, the more 'stimulus' that's pumped in, the greater the concern about the ability of individual countries to cope with the levels of debt they've built up. That could ultimately lead to a loss of faith in paper currencies, particularly those of heavily-indebted developed economies.
So the best way to think about gold in the longer term, rather than as a specific hedge against either inflation or deflation, is as a currency. A currency that cannot be debased or undermined by any government.
Central banks in emerging economies certainly seem to be looking at gold that way. Bloomberg reports this morning that the International Monetary Fund has sold 200 metric tonnes of gold to the Reserve Bank of India for $6.7bn, between 19 October and 30 October. That accounts for almost half of the 403.3 metric tonnes of gold that the IMF plans to sell this year to shore up its finances. That's about an eighth of the IMF's stockpile.
The average price came in at around $1,045 an ounce. Pretty punchy stuff. "The most important thing is that people want gold even at these prices," as Ghee Peh of UBS AG in Hong Kong put it. But it's perhaps no surprise that India's happy to buy gold at these prices. After all, it also holds a total of $285.5bn-worth of foreign exchange reserves. Gold accounts for way less than 10% of that total. If economies like India and China get really worried about the outlook for the dollar, there's plenty of scope for them to buy more.
Our recommended article for today
Canada is having a good recession, and will do well in the future from its abundant natural resources. Here, David Stevensons explains five of the best ways to grab a slice of the profits.
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