Your Money: Good fun while it lasted ...

As interest rates start to rise again, it's time to take a hard look at investments, says Guy Monson

Over the last few weeks I feel have been living the last days of an old regime that survives off past glories, with no concept of its own vulnerability. Equities in London, New York and most of Continental Europe have all hit new highs, with investors still partying as if the good times will never end. However, slowly but inexorably, interest rates are rising - first in the Anglo-Saxon world, and soon perhaps in Tokyo.

Tighter money has already claimed its first victims, with a currency crisis in Thailand and a sudden collapse in the yen/dollar which is sure to take some hedge funds with it. If, as seems likely, the Federal Reserve continues to raise US rates, there will be more pain to come.

Rising interest rates can take even the seasoned investor by surprise. The most famous example was in February 1994, when the US Federal Reserve finally raised rates from the ultra-loose 3 per cent level which they had been using to shore up a distinctly wobbly American banking system.

Despite being widely heralded, this managed to deliver the worst bond market "crash" for 30 years. The possibility of a repeat lies today in Japan, where they have also used ultra-loose money to jump-start an even sicker financial sector.

After two years of short-term rates, banks and finance are at last showing a flicker of life, while in the wider economy there are clear signs of recovery. In response, the Bank of Japan is already closing the liquidity tap and, as in the US, that means rising investment risk across all world markets.

One thing investors should have learnt by now is that a change in liquidity in one country can, with free-flowing global capital, have consequences in seemingly unconnected areas. In this instance a squeeze in Japan may well leave the Nikkei relatively undamaged, especially if accompanied by a rising yen (hence increasing the risk for locals investing overseas). So who will suffer most? The obvious candidates are those markets that have risen furthest, which means Wall Street, along with some of this year's European stars.

But the major Western markets, and within them the international "blue chips" that have led the rises, are rather better protected than many might think. Their strongest defence has been a series of spectacular profit increases.

In the US, beating analysts' expectations is becoming almost commonplace - more than 50 per cent of companies did so again this quarter - while in Europe radical corporate restructuring, weaker currency and a clear management focus on profitability continue to transform profit margins.

This sort of performance can give protect investors if market conditions deteriorate. Daimler Benz is a good example: the company's shares have risen by a staggering 63 per cent over the last 12 months - a typical example of a liquidity-induced bubble, you may say. Yet estimates for next year's earnings have grown faster than the share price, and Daimler's P/E ratio today is lower than a year ago.

Many blue chip stocks on Wall Street, and their new counterparts in Europe, should survive the onslaught of tighter money - as long as they can keep earnings flowing.

So, if the big market leaders are relatively safe, who are the financial "stragglers" that will be picked off first, as tighter liquidity starts to bite? My sell list includes:

Shares in the second or third best company in a sector that seemed "cheap at the time", but whose products or brands are clearly inferior to the market leader.

Medium-sized companies without global distribution, sophisticated information systems or other clear advantages.

Illiquid smaller companies in all markets.

Industries or companies that are highly vulnerable to price competition in a low-inflation world (retailers, computer hardware manufacturers, even telephone operators).

Large positions in emerging or smaller Asian markets, both of which are geared, plays on world liquidity.

In an environment of tighter money an investor can still make good returns, but the cost of being wrong is much higher. This means the rising markets of the last few weeks offers a particularly good opportunity to weed through portfolios and extract lame ducks relatively painlessly. If you are in any doubt as to whether they qualify on my terms then sell, and ask questions later.

But do not sell everything. Top-quality international companies in strongly growing global industries are still wonderful long-term investments. In other words, you don't have to leave the party altogether, but time is running out, so only dance with the people you really fancyn

The writer is investment director at Sarasin Investment Management.

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