To illustrate how the unthinkable has become thinkable in the past year, four events stand out: the financial crisis that originated in the most sophisticated financial system in the world, the bank runs that occurred in the U.S. and the U.K., the banking system worldwide raising $350 billion in capital--which was wiped out by write-downs, and a significant amount of that capital coming from emerging-markets countries.
Investors have to take into account the difficultie
s that policymakers have in dealing with inflation, unemployment, a weak dollar, and the health of financial system. When thinking about our investments, we must keep in mind that no solution solves all these problems.
The signs of major global change came through disruptions at the heart of the U.S. financial system, and in spite of heavy losses on Wall Street and institutional failures, the strength of emerging-markets economies will keep the global economy humming along. Though the rest of the world hasn’t been able to navigate a lot of the bumps, these countries will also have to deal with the consequences of the damaged credibility of sophisticated financial systems and highly leveraged institutions and transactions.
To navigate in these uncertain times, we must understand that the market is telling us something. Looking back, the emerging economies (post the Asian/Russian/Argentinean crises of the 1980s/1990s) and the corporate sector (post the Enron and WorldCom collapses) were the last sectors to recapitalize, and today the financial sector will continue to come under the pressure of shrinking balance sheets and higher regulation. We also need to think about pressure on the consumer sector down the road, especially since the consumer is facing declining housing prices. Borrowers can’t rely on housing prices to go up, and so the credit they used to be able to get through their mortgages has dried up.
Essentially, yesterday’s market is colliding with tomorrow’s, and we as investors need to decide which market we’re targeting to manage the transition. We need to expect the bumps in the years ahead to be like unexpected air pockets, so we need to know what risk levels we can handle and choose our investment management accordingly. We need to hard-wire ourselves to second-guess our assumptions and think about how cyclical events and long-term trends will affect our investments. Also, don’t get paralyzed by all the information and avoid investing altogether!
Some “Don’ts” to emphasize the above points:
- Don’t treat the past year as a one-off situation.
- Don’t think we are going back to business as usual.
- Don’t forget that crises have created opportunities.
- Don’t be fooled by the trap of narrowly framing asset class choices, since all investment portfolios will have to live through a bumpy transformation in the years ahead.
