Secrets of Success: The prophets of doom are overdoing it

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The Independent Online

Through my letterbox (and perhaps yours also) drops a flyer this week offering me a report on "How to Survive The Looming Investment Crisis Ahead".

Through my letterbox (and perhaps yours also) drops a flyer this week offering me a report on "How to Survive The Looming Investment Crisis Ahead". In it, you will find dire warnings of the terrible things that lie ahead for the unwary investor as we enter - so the report warns us - a period of crashing share prices, an imploding dollar and a severe world recession. The warnings are reminiscent of the equally dire warnings about the "next great depression" that older readers might recall being popular in the early 1990s. This is not entirely surprising, given that the publication comes from the same source.

As we now know, the recession of 1990-1992 was a deep and nasty one, but it did pass and ushered in a golden decade of sustained economic growth and booming markets - anything but the wipeout that had been so confidently predicted by the prophets of catastrophe. ( Picnic on Vesuvius was, I recall, the graphic title of a collection of alarmist essays written by Lord Rees-Mogg, the former editor of The Times, who is a leading member of the school).

Should we take the latest warnings more seriously? No, in the sense that the colourful language which is typical of this kind of warning clearly owes as much to marketing considerations as to altruistic concern for the welfare of those to whom it is addressed. To get noticed in the investment world, experience shows you often have to lay on your message with a trowel. This is not always helpful to the ordinary rational investor who only wants to know what is best to do, not to be promised the earth or scared out of their wits.

But there is the kernel of an important truth lying behind the messianic language of the prophets of gloom (whose message in more moderate form can also be found in the writings of some mainstream commentators). This is that the current global financial system, dominated as it is by the imbalances of the United States economy, cannot continue indefinitely as it is. Something will have to give. There is no reason why the process of adjustment to a new global financial order should be a smooth one.

One reason why it has been possible to take a fairly relaxed view about the stock market over the past 18 months is the phenomenon shown in the chart. The amount of real liquidity that has been injected into the world economic system has now reached unprecedented levels. The deliberate low-interest-rate policy pursued by the Federal Reserve for the past three years, designed to hold off the more severe recession that might otherwise have followed the bursting of the stock market bubble and the associated capital spending boom in 2000, has clearly worked in a narrow sense. It has helped to keep the US and world economy growing, but at a price whose longer-term consequences have yet to be felt.

The results of the massive injection of liquidity can be seen in a number of different ways: a falling dollar, a fast-growing current account deficit between the US and the rest of the world, a near-global boom in property prices (also fuelled by a frightening increase in household debt) and the revival of stock markets since early 2003. In normal circumstances, you would expect to see this injection of liquidity reflected in an increase in inflation, but the evidence for that is still ambiguous.

Put all this together, and you have a state of affairs in the world that cannot be sustained as it is. What is giving for the moment is the value of the dollar, which has been falling steadily and looks set to go on doing so, until or unless the Americans start to take remedial action to stem their large trade and government deficits. Leading economic indicators suggest that the world economy is set to slow down; at some point, the expansionary policy of the Federal Reserve will have to be curtailed. The prospects of a recession of some kind in the US in the next two years consequently seem quite high.

It is right to adopt a cautious outlook about the medium-term prospects of most classes of investment asset. In the short term, however, as I noted last week, the prospects of a further rally in share prices look pretty good, as they seem attractively priced relative to bonds, their immediate alternative. The bond markets are meanwhile going through a period of schizoid uncertainty, torn between the fear of inflation returning (which would normally push bond prices down and bond yields up) and the risk of economic slowdown (which would normally do the reverse).

Bond yields and the interest rate/exchange rate policy of the US will remain the key things to watch as this story unfolds. As for gold and oil, two other important indicators that feature largely in the warnings of the doomsday prophets, they tell a mixed story. Yes, the price of both has risen in the past 18 months, but as they are both priced in dollars, the effective cost to the rest of the world has been mitigated to an extent by the fall in the dollar's value.

The bottom line is probably that the investment world has become dangerously attuned to the idea that the business cycle has been abolished. There hasn't been a bad recession in the US since the early 1990s, although there have been periodic downturns in other parts of the world, including Asia and mainland Europe. We have also survived a savage bear market in the stock market with surprising ease so far.

If there is a danger for investors, it is not, I suspect, the global depression that the doom-mongers expect, but complacency in the face of the undeniable fact that the liquidity medicine that has been prescribed in such massive doses in the past three years cannot work its wonders indefinitely. Being underweight in property, long of commodities, and mildly underweight in equities, with a strong defensive component in your portfolio (and cash where possible rather than debt), seems an appropriate strategic stance until the picture is clarified.

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