Investment Risk and the Seven you should avoid in 2010

BY LARRY D. SPEARS, Contributing Writer, Money Morning

Spurred by its best annual performance since 2003, U.S. stocks stampeded into the New Year, with the Dow Jones Industrial Average, the Nasdaq Composite Index and Standard & Poor's 500 Index posting gains of 1.49%, 1.73% and 1.60%, respectively. And while that's certainly a respectable beginning, investors shouldn't assume it signals that a bull market run its course for the full year.
Indeed, while Money Morning's outlook for 2010 is generally positive, there are at least seven major risks that could rein in the charging bull - or even release an angry bear into the trading arena. The top risks consist of:

Obviously, several of these risks are interconnected. But the No. 1 investment risk this year - and the most likely to occur - is a crisis in the bond market, most analysts, including both Money Morning Chief Investment Strategist Keith Fitz-Gerald and Contributing Editor Martin Hutchinson, feel.

A Look Back......

After bottoming in mid-June, prices for U.S. Treasury bonds and 10-year notes advanced for most of the second half of 2009 before showing renewed weakness in the final days of December. The impetus for the rally was, of course, the highly accommodative interest-rate policy of the U.S Federal Reserve, which has stubbornly held the benchmark Federal Funds rate at near-zero levels in a continuing bid to invigorate the economy and keep the recovery on track.

And based on the just-released minutes of the policymaking Federal Open Market Committee (FOMC) meeting from December, that policy is unlikely to change substantially in the near future. Officials indicated the Fed still plans to complete its scheduled purchase of $1.4 trillion in mortgage-backed securities (MBS) and other debt issued by Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) by March 30. But central bankers gave no hint about the timing of possible interest-rate increases - the so-called "exit strategy" that has pundits and experts alike so concerned.
"Some (Fed) participants remained concerned about the economy's ability to generate a self-supporting recovery without government support," the FOMC minutes state. "In particular, they noted the risk that improvements in the housing sector might be undercut.... as the purchases of MBS wind down, the homebuyer tax credits expire and foreclosures and distress sales continue. It might become desirable at some point..... to provide more policy stimulus."

The Fed's Hobson's Choice....

Without the benefit of such additional stimulus money, mortgage interest rates are sure to rise - perhaps by enough to stall the recovery in housing and to spark increases in other rates, such as those for business loans and credit cards.
That's the primary reason the Fed is being so closed-mouth about its intentions. If it raises rates too soon - or by too much - it could stop the recovery in its tracks. But if the central bank waits too long - or fails to act at all - the market's growing fears about inflation could become reality.

"All eyes are on the Fed," explains Fitz-Gerald, the Money Morning investment director who's been an outspoken critic of Federal Reserve policy for most of the past decade. "If the Fed alters its accommodative stance even moderately, investors will fear more tightening is likely to follow and the bond market will do an about-face, sending [that] market sharply lower. That could spike other rates higher, choking the recovery and dragging stocks down, too."

Fitz-Gerald agrees with the few FOMC dissidents who contend that the Fed should cease providing stimulus and let the market work its way out of the present dilemma.

"The government should just step aside and let the markets sort the economic situation out, which they will ultimately do anyway," Fitz-Gerald says. "The problem is that a large number of financial analysts - both inside the Fed and out - fail to understand the impact of various monetary moves, so they don't really know what policy actions they want. As such, it's safer for them to favor no action at all until the economic data shows clearer signs of a recovery."

Money Morning's Hutchinson agrees that there's trouble ahead for the bond market. The severity of those problems will depend upon the public's reaction to such issues as continuing monetary stimulus, the ballooning federal budget deficits and steadily rising inflation, which is the second-most-likely investment risk in 2010.

"I think inflation could rise much faster than expected," Hutchinson predicts. "It's possible it could hit 10% - 0.8% per month - by year end, especially if commodities prices keep rising. As inflation grows and [Federal Reserve Chairman Ben S.] Bernanke does little about it, rates on long-term Treasury securities will have to rise, and that will make funding the deficit [$1.4 trillion in fiscal 2009, with another $7 trillion projected in the coming decade] even more of a problem."

As evidence of that problem, the government had to boost yields above recent averages on two of the three classes of U.S. Treasury notes offered in late December's $118 billion auction. That further supported predictions in Morning Morning's December 11 article that bond yields may soon defy the traditional laws of financial physics and rise sharply - whether the Fed increases benchmark interest rates or not. That could send bond prices into the tank and, with yields at abnormally low rates historically, investors in bonds and bond funds would suffer even more than usual when rates rise.

Money Morning's Fitz-Gerald also feels inflation will eventually get out of hand if current policies persist, but most members of the FOMC discount those fears.
"The bottom line is that the Fed has said they are going to do what they have to do to support the recovery," New York University Professor Mark Gertler, who co-authored several papers with Bernanke, told MarketWatch.com. "And the majority view on the Fed - not the universal view, but the majority view - remains that inflation is not a problem now."

Recessionary Risks....

Increases in interest rates and inflation could also have a domino effect. The recovery could stall and send the economy into a double-dip recession, a decline that's aided by a collapse in commodity prices, which Hutchinson sees as likely if interest rates shoot up. Higher mortgage rates could also trigger a new banking crisis, as lenders with unrealized real estate exposure have to deal with a new wave of defaults, foreclosures and falling property values.

Slow business formation and a lack of job creation are two other warning signs relative to a possible economic reversal (into recession), something the Fed noted in its December FOMC meeting. When it was reported that the November employment report was better than expected, Fed officials observed that, "more than one good report would be needed to provide convincing evidence of recovery in the labor market," and this recovery will be "gradual relative to past recoveries."

The Fed hasn't acknowledged the danger of renewed real estate problems, but it did hint that it was aware of the possibility when it announced on Christmas Eve that it would "remove any and all limits on aid to Fannie Mae and Freddie Mac for the next three years," abandoning its current $400 billion aid cap.

Fitz-Gerald, the Money Morning investment director, doesn't see another full-blown banking crisis in the coming year, but he does say that banks need to be pressured to ease tight credit practices and to put more money onto the street, where it can be used to create new businesses and new jobs - a far more beneficial approach than just a straight governmental bailout.

Global Concerns....

The final three major risk factors have more of an international flavor, though the first begins with attitudes at home, Fitz-Gerald says.

"One of my greatest fears is that our leaders in Washington will do something stupid with respect to China and other rapidly developing economies, primarily in Asia," Fitz-Gerald says. "It could involve new fair-trade acts, currency controls, import tariffs - those types of mistakes. There's a growing populist agenda in this country, with lots of talk about protectionism - a very dangerous attitude. Anything that cuts American consumers off from other countries will raise prices 50% to 60%, and the inflation we've been exporting will come home to roost."

To avoid these problems, Americans must adopt a new mindset, he says.

"Our leaders and our media love to portray China as a villain, but a huge part of the world sees China as a hero, and we need to recognize that and adapt if we want to compete," Fitz-Gerald says. "China has cash reserves, and it's using them to buy key companies and resources in key industries all over the world, which means we'll soon have to deal with them whether we want to or not. Either that or starve economically."

With Asian economies leading the way out of the global crisis, with the United States and Latin America making slow-but-steady progress, Europe is struggling with an assortment of problems - the foremost being the growing differences among the individual European countries. These became vividly clear in recent weeks as debt-ridden Greece teetered on the edge of default and the stronger members of the European Union - only Germany and France can actually be so described - declined to offer aid.

And Greece is not alone. Ireland and Spain are also deep in debt with negative growth forecast for 2010 - and Great Britain is burdened with the same bailout-driven liabilities as the United States.

This internal turmoil bodes poorly for investors in Europe, but the greater investment risk is the potential collapse of the euro as an international currency. The euro, a little over a decade old (though it didn't become the European Union's "official" currency until the Treaty of Lisbon took effect on Dec. 1, 2009), is used by 16 of the 27 EU member countries and freely traded throughout the continent. It's also the world's second-largest reserve currency after the U.S. dollar.

However, Greece and Spain are talking about exiting the euro currency pact, complaining that valuations don't reflect their internal problems, and instead work to the advantage of the stronger members.

"That would definitely shake up the European markets," says Hutchinson, a veteran global investment banker who understands the international banking system from the inside out. That would have the effect of "negatively impacting investors in both European stocks and bonds, as well as sector and international funds."

Fitz-Gerald also sees trouble for the euro in general - and says its collapse could significantly impact international trade and financial affairs.

"We may have a situation where, if one rat - say Ireland or Greece - deserts the ship, others will quickly follow and the whole euro accord could fall through," he says. "That would be a problem because the dollar's role as the world's reserve currency is already being challenged, and the loss of the euro could leave nations with no viable currency for trade - although China is steadily moving to establish the yuan as a reserve currency by negotiating an increasing number of trade and exchange-rate pacts."

While loss of the euro would be daunting, Hutchinson sees a potentially greater problem arising from the unsettled economic situation in Europe, as well as the debt problems there, in the Middle East and even in the United States. The problem: A possible government default.

"Sovereign debt is rising around the world as countries try to buy their way out of the recession or recover from overspending that seemed reasonable until the crisis hit," Hutchinson says. "The problems in Greece and the recent request by Dubai to delay repayment on $60 billion in construction loans are just the first clangs of the alarm. Debt problems can be contagious and Dubai's semi-default hit Europe hard, adding to the woes in Spain, Ireland, Italy and Portugal, among others."

The result of all this, according to Hutchinson: "We could face the very real possibility of government default, both overseas and here in the U.S.," he told Money Morning. "Economists tell us that governments can't default on bonds in their own currency because they can always print more money. For troubled European nations, however, the euro isn't technically their own currency - individual countries can't print more.

History is a guide, he says.
"As Germany's Weimar Republic demonstrated after World War I, printing money doesn't always work, either," he says. "It causes hyperinflation and, in essence, results in default by default."

How to Navigate the Risks....

Hutchinson says default isn't a major risk for U.S. government securities since the Fed can, indeed, print money, and Uncle Sam can both engage in deficit spending and carry a national debt. However, default is a distinct possibility for state and local governments, which usually can't run a deficit for more than one year. Thus, the risk could be very real in hard-hit states like California and Michigan.

While that would be damaging to holders of the specific debt, Hutchinson says outright default by a government might be better for the financial system as a whole because it wouldn't completely destroy the value of non-government bonds and shares - which he advises purchasing to the exclusion of government securities.

"After all," he explains, "which would you expect to provide better investments: Private companies, which create value, or the various government entities, which merely spend money?"

Fitz-Gerald also advises 2010 investors to stick with stocks, saying they really have little choice in the present environment.

"The Fed has thrown an unbelievable amount of money at the economy and there are indications more will be coming," Fitz-Gerald says. "It has also diligently supported the market with artificially low rates - and as long as it continues to do so, we have to be long stocks. The adage definitely applies in this case: 'Better to be long than wrong'."