This article has been adapted from Fool U.K., our sister site across the pond.
The financial crisis is entering a new, dangerous phase. But while it is risky to try to predict what will happen next, this does not mean that you cannot take steps to protect your portfolio, or even to enhance it, during the turmoil ahead.
The snowball effect
Let us take a step back and consider how the crisis has unfolded so far.
It started during the summer of 2007 when some investment funds that owned subprime securities collapsed. From there, the crisis moved on to banks, including Northern Rock (September 2007), Bear Stearns (March 2008), and Lehman Brothers (September 2008).
After the banks came countries: Iceland (October 2008), Greece (May 2010), Ireland (November 2010), and then Portugal (April 2011).
Although the underlying causes were different, the fundamental problem was essentially the same in every case: These funds, banks, and countries were simply insolvent.
Lessons so far
We cannot predict the future, but two conclusions emerge from the story so far:
- the entities collapsing under the weight of their own debt are getting larger, from funds to banks (of increasing size) to countries (again of increasing size); and
- there is no evidence that any government or institution is on top of this crisis, or able to stop it. We do not know whether this pattern will continue, but we have to assume that it might.
It's not just the peripherals
If Greece defaults on its debt, as is now widely expected, a similar move may follow in Ireland or Portugal, two countries that also face decades of painful, grinding austerity if they are to repay their national debts the hard way.
Rising yields on Spanish and Italian debt suggest that concerns about repayment are spreading further afield. But Spain and Italy are not the end.
The national debts (including off-balance-sheet liabilities like unfunded pension and health care promises) of both the U.S. and the U.K. are also far higher than the 90% of GDP threshold at which national debt is considered to become dangerously unsustainable.
Strategies for survival
Here are five suggestions for surviving the next phase of the financial crisis.
Dollars may go up tomorrow, or maybe equities, or gold, or commercial property, or farmland. The markets are still driven by fear and will continue to gyrate wildly depending on which asset class is perceived to be the safest at any particular moment.
Maximum diversification should help avoid a wipeout when the next panic sets in.
2. Seek liquidity
Many recent crises, like the Irish and Portuguese bailouts, were flagged some weeks ahead. Future crises may also be preceded by a period of increasingly loud warning signals.
If your assets are liquid then at least you have a shot at moving them out of harm's way before the hammer falls.
If not, for instance if your assets are tied up in land where transaction times are measured in months rather than minutes, you will be much more vulnerable.
3. Avoid assets tied to countries at greatest risk of default
Historically, defaults by countries have been followed by collapsing property prices, recession, and currency devaluation. Each of these will hit foreign investors particularly hard.
As foreign investors cannot vote, expect the same to happen in the future as well.
4. Think the unthinkable
The crisis has already reached a stage unthinkable even a year ago; why should it stop now?
The U.S. may default, if only for a few days; Spain may require bailing out; Greece or even Germany may leave the euro; or something else of equal magnitude might happen instead. The only thing we can be certain will not happen is the Rapture.
5. Be prepared for another credit freeze
If a Western country defaults, expect a temporary panic and possible freeze on future lending as markets and governments rush to assess where the losses will finally fall.
Lastly, watch out for inflation. Countries that issue debt in their own currency, like the U.S. and the U.K., are less likely to default openly on their debts as they can simply print the money required to pay them off. However, they may not be too concerned if higher-than-average inflation eats into their debt for a while.
Inflation is generally much more acceptable politically than other forms of default, but it is default all the same.
Am I being too gloomy, or perhaps even too optimistic? Let me know in the comment section below.
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