The Year of Living Dangerously.

Which, I wonder, would be the riskiest thing to do this year, if you felt like a bit of excitement? Invest heavily in equity markets, invest heavily in government bonds, or buy a used Toyota from someone you don’t know?

Leaving aside the Toyota issue for the moment, there are plenty of opinions about the advisability, or otherwise, of the other two courses of action. Equities in Europe finished the first week of February at, or close to, three month lows. That week saw the worst weekly performance for nearly a year. The Dow Jones over the last few days has often looked like fear had definitely triumphed over greed in people’s minds. The index, which was over 10,700 in late January, has, on February 8^th fallen to 9908.

Short term moves like this will put doubt into the minds of all but the most ardent bulls and lead to the question; is this downward move a blip or the start of a major correction?

In coming weeks there will be many headlines proclaiming a further market rally- and on other days many warning of a bear market run. Whatever the short term factors moving markets, two international problems are not going to go away in a hurry and will loom larger in people’s minds as the year goes on.

Firstly, how successfully will five European Nations that are part of the single currency, namely: Portugal, Spain, Greece, Italy and Ireland cope with huge deficits and other economic problems without having the ability to devalue their currencies, as they would have been able to in past recessions? Bear in mind the EU constitution forbids bail-outs in all but exceptional and unavoidable circumstances.

If they can’t reduce budget deficits quickly and decisively, can the single currency survive?

Secondly; when and how will the UK, the USA and others withdraw their stimulus programs from their economies and can the global recovery survive them doing so?  If it can’t and a double dip recession becomes a reality, whence equities then?

As far as government bonds are concerned, there is a need for massive issuance this year. This means that yields are likely to rise, possibly bringing rises in base rates, which will put pressure on the housing market recovery in those countries affected and increase the levels that businesses have to pay for borrowings to fund expansion. All at a time when credit is hard to come by and growth is slow.  You certainly get security from owning government bonds, but will investors become more selective about which country’s bonds they are happy to hold? Any downgrades of major western economies, such as the USA or the UK could have a significant effect on the level at which they can issue their debt.

So with government bonds you buy in the face of massive issuance, with equities you are possibly pricing in most good news at February 2010 levels and running the risk of negative macroeconomic events starting another major sell off.

If you want to play it safe, there’s always that second hand Toyota being advertised in the local press...