Global guide: Small can get ugly

It's a small world after all. Investors should sing that little ditty every time they contemplate opportunities beyond Canadian borders. Learning it doesn't require a trip on the mind-programming Disney kiddie ride. Indeed, even memory-challenged market players can probably still recall China's Black Tuesday, otherwise known as Feb. 27, 2007, when a sudden panic among the shareholders who play Red Capitalism's mainland markets, Shanghai and Shenzhen, tripped up the global bull.

Average investors, however, might not know how the Bank of Japan's monetary tightening earlier in February contributed to the equities sell-off. They also probably don't understand the importance of what happened about a year ago, when the BoJ started unwinding the so-called yen carry trade.

Japan's former zero-interest-rate policy allowed savvy investors to borrow yen for next to nothing and use the loans to buy what they hoped would be higher-yielding assets elsewhere. When the nation's central bankers started raising rates, it was a small world, too. one that experienced a five-week flight from stocks and bonds that lifted trillions of dollars from the global pocketbook. That, of course, was nothing compared to what happened a decade ago, during the summer of 1997, when weakening U.S. growth and rising rates helped crash the Thai baht, which scorched the global economy and sparked the Asian financial crisis.

Canadian investors should remember how these economic shocks crossed borders, because the next major currency crisis could hit closer to home.

Despite the rise of China, the global economy still revolves around the United States. And according to pretty much every central banker on the planet, not to mention the International Monetary Fund, the greenback remains significantly overvalued, even after recent downward adjustments. With trillions in dollar-denominated assets floating around the world, other stakeholders (such as the Bank of China, which reportedly holds dollar-denominated reserves worth at least a trillion dollars) have an interest in keeping the American currency overvalued. But unless the twin deficits somehow improve, economic law dictates a correction must come eventually. Economists around the world have been watching out for what European Central Bank president Jean-Claude Trichet, when he raised rates in December, called “possible disorderly developments owing to global imbalances.” (To the rest of us, that's econo-speak for a sudden run on the greenback.)

Hans Martens, head of the European Policy Centre, a Brussels-based political and economic think-tank, has a colourful explanation for the current state of American monetary affairs. “When you pee in your pants, it gets warm for a while,” he told Canadian Business earlier this year, “then it gets RFC [really f—ing cold].”

For some time, everything has depended on the temperature in Uncle Sam's pants. which are now being chilled by inflation and the need to reward the risk-taking foreigners who support the United States' ability to overspend. That could pressure Federal Reserve chairman Ben Bernanke to further raise interest rates, a move that could slam the brakes on the world's largest economy, which is already fighting a housing slump exacerbated by the sub-prime mortgage crisis.

Simply put, Bernanke may be damned no matter what he does. Mixed messages abound. Some market bears foresee a U.S. recession. Others are talking stagflation. A soft landing could still be in the cards, but market-watchers such as John Calverley, chief economist at American Express Bank, insists the best-case scenario looks bumpier every day. Share prices south of the border. where the short interest on S&P 500 companies jumped 5.8% between mid-March and mid-April as the market digested America's lacklustre GDP growth of 1.3% in Q1. could tank so fast that some institutional economists won't even talk about the potential repercussions, at least not on the record.

What should investors do? If you don't have a stomach for risk, listen to Gerry Schwartz. “When it comes to severe economic downturns,” he says, “the one thing I'd never say is . Never again.' There are confluences of events that can still create terrible recessions. The likelihood of a 1930s-style depression has been materially reduced by the sophistication of financial markets and central banks, but it isn't impossible.”

Schwartz might be wrong about the sophistication of central bankers (more on that later), but the Canadian king of private equity clearly knows more than a thing or two about investing. And he thinks anyone who can't afford a lot of risk should ditch high-return expectations. If that's you, think D&D. defensive stocks and a diversified portfolio (not Dungeons and Dragons). Or better yet, take some profits and pay down debt.

According to Calverley, now is not the time to look for new opportunities. “It is probably too risky to get out of the market if you are a long-term investor and probably too risky to get in if you play short term,” he says. But plenty of Street folks think differently. So if you have play money, keep in mind that neither the S&P/TSX composite index nor the S&P 500 has ever declined during the third year of a presidential cycle. Furthermore, years like 2006, which ended with a stronger-than-usual rise in equities, are typically followed by better-than-normal equity gains. These facts were highlighted earlier this year by UBS Investment Research, which thinks investors will continue to appreciate the S&P 500's “significant exposure to the vibrant global economy” over coming quarters. The current UBS 12-month target for the index is 1,650.

Now, UBS may be stretching a bit to defend its bullishness, but there is simply no clear reason to “Sell in May and go away.” The silly logic behind this seasonal selling adage is the 1.6% average return for the S&P 500 for all May-to-October periods since 1945. Follow it and you would have lost a bundle selling Microsoft in May 1997, or Research In Motion in May 2003. New Jersey. based Cumberland Advisors knows how foolish May sellers (if they really exist) can be. In a recent report, the firm sliced and diced the seasonal return data by also looking at what was happening at the Fed. It found you should indeed run for the hills during summers in years in which the Fed was tightening, but not when central bank policy was easing. What about when U.S. rates are on hold? The results were mixed, which is why there is no seasonal reason to sell today. unless you know what Bernanke will do next. And right now, as Cumberland notes, “anything but an agnostic view about the Fed's next move is speculation.”

The wealth management firm is playing a game of wait-and-see, maintaining a neutral position in its bond portfolios and remaining fully invested in stocks worldwide. “We do not see reasons for intense selling pressure,” reports Cumberland chief investment officer David Kotok. “Under current conditions, stocks are cheap relative to bonds and should be owned, not shunned.” In fact, if all goes well stateside, Kotok argues it might just be a great time to fall in love with North American tech plays again.

What about overseas markets? Avoid Japan (see page 62), where the government can actually delay supposedly independent rate decisions made by the central bank. The European Monetary Union might also be a good place to take a pass, since its stocks could soon give new meaning to the term “Eurotrash.”

The European Central Bank is currently mimicking the U.S. Federal Reserve, desperately hoping inflation will go away before it forces tough-love policy measures on its own economy. “I am reminded of an old Three Stooges comedy routine in which one of the Stooges dares a bully to step over this line, then draws another and dares him to step over the next and the next,” says independent American economist Robert Brusca.

Despite the stalling, however, higher EMU rates are probably coming, and that would push the already strong euro even higher. And while EU officials insist German exports. a key leg to the European economy. can cope with the multinational currency going as high as US$1.40, such confidence should be taken with a grain of salt. (Indeed, Canadian Business recently spent 10 days in Brussels and Frankfurt asking how high the euro could go before competitiveness troubles started. None of the dozens of senior officials questioned would admit euro strength could become an issue; one even denied that policy-makers even take it into account. And this was off-the-record, not to mention after free-pouring wine.)

Bottom line is that EU spokespeople rarely say anything newsworthy without a press conference, and they would certainly never come out and say, “Our exports are doomed.” Colonials are another story. “I do not think the EMU countries are going to simply brush off the strength of the euro,” Brusca warns. “Nor do I think that the internal EMU market has strengthened enough for firms to power through this adverse competitive position that euro strength has thrust upon them.”

British stocks, on the other hand, may be in for a value boost thanks to. believe it or not. the taxman. Treasury officials in the United Kingdom are drafting a proposal to allow multinationals to repatriate foreign profits tax-free. A similar move in the United States injected almost US$400 billion into the American economy over the past few years, lifting equities and helping the greenback avoid a correction. (If you recall, the dollar rallied in 2005, strengthening 14% against the euro, before weakening 10% last year.) If all goes as expected, British repatriation would push the pound toward US$2.20 (and probably the euro past the stated US$1.40 comfort zone), while “U.K. stocks should continue to perform well in anticipation of greater flows into the [economy] to fund Britishstock buybacks and pay dividends,” concludes a Cumberland research note. It points out that repatriation flows in the U.K. would probably equal about 3% of the economy, making the impact proportionally larger than the U.S. experience.

The MSCI Emerging Markets Index is currently running the longest winning streak in its 19-year history. And developing world stocks are now the most expensive since 1999 (relative to developed world stocks). Still, emerging markets. where UBS estimates profits of consumer product and services firms will increase an average 30% this year. may be the place to invest again this year. You may not see the returns that came last year, when the MSCI. which tracks 25 markets in Asia, eastern Europe, Latin America and the Middle East. posted a 29% gain, while Morgan Stanley's index of developed markets jumped 18% and the S&P 500 increased 14%. But returns above 15% are not out of the question in 2007.

To play it relatively safe, stick to countries or regions where ETFs exist (China, Singapore, Hong Kong, Brazil, Mexico and South Africa) or buy broad ETFs linked toa bundle of developing nations. And if you want to drill down into the so-called BRIC nations, stick to Brazil and China (or at least the Chinese stocks traded in Hong Kong), where consumer spending is growing at a rate of 13% and the middle class is expected to double in size over the next five years. They could be safer bets than semi-lawless Russia and India, where the economy is on shaky ground.

What is so different about the Indian and Chinese economies? Both have been growing at rates of 9% to 11% per annum. Both have stock markets that have registered huge gains. And both have raised concerns about overheating. But while India's economic reforms have it on the way to becoming third-largest economy in the world, it is encountering capacity constraints and infrastructure bottlenecks. As Cumberland notes, India's current account deficit was equal to 2.3% of GDP last year and is projected to grow to almost 4% next year. “The contrast with China's current account surplus of 9.1% of GDP last year is striking,” it concludes.

Whatever you decide, remember that markets have been hitting record highs at a time when across-the-board rate hikes by the major central banks could be in the cards. Note that returns from foreign investing are affected by currency fluctuations. And keep in mind there is no such thing as a shot at high returns without taking high risks. That's why players like Gerry Schwartz will gladly live with a 3% return. if that's what it takes to keep him around to invest another day.