Equity markets are rising but in many ways 2011 is feeling a lot like 2009. Is there another global financial crisis heading our way? And if so, how should you respond regarding your own portfolio?
Even though it feels a bit like Groundhog Day, there are different forces driving the problems.
Last time we saw too much debt in the private sector. Now we're seeing debt moving to the public sector.
Last time, instead of facing the collapse of banks, now we're dealing with a larger problem of extremely high levels of debt in sovereign countries like Europe, UK, US and Japan.
Across the globe, there are three different solutions to this situation that are playing out:
One: take the austerity route and cut spending. This is the route taken by the UK and Europe.
Two: hope that cash flow or demand increases. This is the route taken by Japan and the US.
Three: default on sovereign debt to trigger a re-structure of that debt. This is the likely scenario in some of the peripheral EU countries.
One of the key decisions for Australian investors and traders in 2011 is how they will react to the sovereign debt situation and the economic imbalances in the world.
There are two schools of thought which are like the toss of a coin.
Heads — the equity markets won't be affected and will continue to rise.
Tails — the global sovereign debt crisis will blow up and equity markets will take a beating.
Most people are thinking the coin will land on tails. These macro issues won't go away any time soon and we are going to have to deal with the consequences.
So the real question now for you is one of timing. Will the sharemarket crash this year? Next year? In 2013? What can traders expect?
So what's really going on with the sovereign debt problem?
There really won't be a crisis for sovereign countries unless they can't roll over their debt. Of course spreads on debt will widen but a restructure of debt won't happen unless these countries can't repay their existing debt.
Take Japan as an example of a country which has survived large levels of debt for decades.
Japan had extremely high levels of debt for decades. Their problems first imploded in 1989 when their real estate bubble popped. Now, debt to GDP stands at around 230%. The result has been increases in taxes, anaemic growth and a deflation fight due to lack of demand for goods and services.
Yet Japan did not blow up, despite their huge amount of debt which continues to snowball.
But it's not all good news. The problem now is that Japan faces a decline in household savings due to their declining population growth. This demographic shift is going to make it much more difficult for the country to manage its debt.
Let's look at Russia. That country defaulted in 1998 triggered by the Asian currency crisis and fall in the demand for commodities. Investors sold Russian assets which led to a fall in the currency and asset prices. Stock, bond and currency markets fell. Then, Russia was bailed out by a financial package from the IMF and World Bank. They bounced back from their debt crisis quite quickly, mainly due to the world-wide rise in demand for oil.
How about Argentina? They defaulted in 2001, but currency devaluation helped manage the economy back to growth. Inflation was a problem in the year after the default — rising by 40% — but by 2003, the economy grew 8.5%.
So in terms of Europe, will we see a GFC II or will it be a drawn-out process with increasing taxes, anaemic growth and the potential for deflation?
The big question with Europe is whether a default in any of those vulnerable countries would necessarily spell disaster for sharemarkets. For example, unlike Argentina, countries in the EU cannot devalue currency.
There are lots of unknowns. Yet we know from other countries that went through sovereign debt crises, the long-term path doesn't necessarily spell disaster even though the short-term impact on sentiment was negative.
All we can really do is prepare for the worst but hope for the best. Risk management will be a key feature in 2011 for mindful traders and investors.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.