Rising interest rates in the U.S. could bring economic downturn south of the border
Malcolm Morrison
Sun
The Canadian investor has had it pretty good over the last few years, with the Toronto market running up more than 20 per cent last year and another eight per cent so far in 2006.
It’s all too easy to become complacent in such environment, but plenty of worries remain.
For example, rising interest rates in the United States could threaten a soft landing for the slowing housing market, possibly sparking an economic downturn south of the border.
And then there are looming geopolitical worries centred on Iran, which cast even more dire shadows across the global fiscal landscape.
“I do regard the potential for conflict with Iran as the single biggest risk to the global economic outlook at this point,” said BMO Nesbitt Burns deputy chief economist Doug Porter.
“Even if there’s only a one-per-cent chance of something happening between Iran and the rest of the world, the possible outcomes are so serious that even a one-per-cent chance is worth paying attention to.”
The country continues to defy orders from the United Nations Security Council to suspend enrichment of uranium, a process that can produce fuel for nuclear reactors or material for nuclear warheads. Iran has rejected the demand, arguing it only wants to harness the radioactive material for nuclear energy.
Western countries are skeptical about the claim and the U.S. has pointedly said all options are on the table to make Iran comply — including a military solution.
The big worry is that a military confrontation with Iran aimed
at destroying its nuclear
capabilities — or setting them back for many years — would result in a big slowdown in
global growth sparked by much higher oil prices.
“At the very least, there would be a huge risk premium attached to all oil prices and there is some talk of oil getting above $100 US a barrel, which I think is quite reasonable,” added Porter.
“It’s as good an assumption as any other, given the circumstances.”
While $100 US a barrel oil may not necessarily knock the economy into recession, “it would be
a fairly significant adjustment and upheaval in financial markets with equities getting hit pretty hard and ultimately some of
the commodity currencies like the Canadian dollar getting knocked down quite badly as well,” observed John Johnston, chief strategist, The Harbour Group at RBC Dominion Securities.
Given the economic shock that a military strike on Iran could have on the global economy, it behooves investors to pay attention to what’s in their portfolio and be prepared to move holdings into more defensive sectors if the standoff seriously deteriorates.
Getting defensive means lowering overall exposure to equities, less exposure to cyclical stocks because resource stocks could suffer badly in a global downturn.
Also: “I would be particularly concerned about anything related to the consumer — consumer weighted stocks, I think, would suffer,” said Porter.
Traditional defensives like financial stocks and utilities that have solid dividends would also be a good bet.
But you might also want to consider bailing out of equities entirely by placing money into a treasury bill fund or short-term bonds.
“You would not necessarily do badly because it’s probable that rates would spike up simply because of the necessity of protecting the U.S. dollar through this disruption,” said Gavin Graham, chief investment officer, Guardian Group of Funds.
“There would probably be a flight to safety so you might want to be in short government bonds because they’re yielding 4.5, 4.9 per cent in the States, four per cent in Canada.”
Gold, on the other hand, could be an iffy hedge.
“Gold hasn’t really been exactly behaving as the textbooks would say in recent years,” said Porter.
“It hasn’t always done very well after crises and it’s been very strong even at a time when global inflation has been quite low in the last couple of years.”
And while you would want to lower your overall equity exposure if it looked like conflict was getting likely, some analysts say you would certainly want to make sure you aren’t underweight in the resource sector.
“Resources are your anchor to windward,” said Graham. “Don’t be underweight in resources, it’s worked for the last few years, it’s going to work for the next few years even if everything goes right on the political front in the Middle East and Russia and Peru. [There will still be] that Asian demand and you have supply constraints.”
Johnston said another reason to think defensively besides growing geopolitical risk is where we are in the earnings cycle right now.
“Earnings are still going up, but the growth rates are coming down,” he said.
“You take that and the high level of complacency in the markets and you add geopolitical risk that may be getting more intense, it is an environment where you need to take on a more defensive posture.”
Johnston added that “it’s probably still a bit early from our perspective to be discussing what happens in the case of a military option being used” against Iran.