How the cheap money era led to the war in Georgia

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It's time to sell Russia

The end of the easy money era and the war in Georgia don't, at first glance, seem to have an obvious connection. But they are linked. Bear with me, and I'll explain why.

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Cheap money gave us many things, including a global property bubble, and a £1.4 trillion debt mountain for UK consumers. Another noticeable trend was a taste for exotic new investment classes, from Iraqi government bonds to obscure derivatives.

All of these trends were the result of falling risk aversion. Investors believed that central bankers, lead by Alan Greenspan, now had complete control of the global economy. Globalisation would ensure economic growth went on forever. And if it didn't, a soft landing could be engineered by judicious use of the emergency interest-rate cut button on Greenspan's miraculous economic control panel.

As investors became bolder, and focused entirely on returns, rather than risks, one brave new investment class, invented entirely by a man working at Goldman Sachs, benefited more than most.

It was called the Brics

The Brics were a great investment, when risk didn't matter

The Brics as you probably know by now - was a catchy acronym for Brazil, Russia, India and China. Jim O'Neill at Goldman Sachs coined the term in 2003, and predicted great things for these four countries.

And he was right. They've all benefited from booming commodity prices (in the case of Brazil and Russia), or booming US consumption (China), or the outsourcing boom (India). But another point has also worked in their favour.

Low interest rates pushed returns down too. As more and more money chased each new investment opportunity, yields fell on all major asset classes. That drove investors, particularly adventurous new players like hedge funds, into ever-more outlandish investment areas.

Risk took a back seat political risk in particular. No one batted an eyelid at putting money into once-frontier markets. "China? Sure, it's a totalitarian regime. And yes, communists have never quite got to grips with the idea of privately-owned property. But this is a globalised economy now. The government won't want to upset investors. Especially not ahead of the Olympics."

Why China and Russia have now become very risky for investors

But free and easy money has vanished now. Now some of the best returns you can get are in good old-fashioned hard cash. And when your best returns come from risk-free assets, suddenly things like political risk matter again.

That's bad news for most emerging markets. And it's a worry for the Brics too, all of which have seen their stock markets take a hit this year.

But it's worse for China and Russia. Brazil and India have their problems, and plenty of them. India in particular has a fractious democracy, terrible infrastructure and chronic corruption. But at their core, they believe in democracy as a model for society, so the chances of dangerous social upheaval are comparatively low.

In China, the chances of a civil breakdown are higher. Economic problems tend to lead to unrest. The uprising in Tiananmen Square occurred at a time of high inflation, for example. We've more on China and the troubles it faces in the current issue of MoneyWeek. If you're not already a subscriber, you can get your first three issues free by clicking here.

But Russia's probably the most risky for investors. The country is a basket-case in many ways. It has appalling social problems including high levels of alcoholism, HIV infection and suicide. And while surveys suggest that the Chinese population seems largely comfortable with the idea of capitalism, ordinary Russians seem to pine for the good old days.

Above all, Russia's recovery from bankruptcy in the 1990s has been built on the soaring oil price. China makes things for US consumers; Brazil has a broad range of commodities for sale; and India has a bright, cheap white-collar workforce. All of those are under threat from the global slowdown, but none quite as much as the price of oil.

All those petro-roubles pouring into the coffers have given Russia back its swagger. But as the deflating credit bubble leads to global economic downturn, the oil price is already falling. That's why if Russia wants to press home its advantage, it needs to do it now.

Hence the stepping up in state rhetoric and confiscation of assets, and its action in Georgia. What's the US going to do after all? America doesn't have any money and all the funds it could borrow are being spent in Iraq. Who's going to risk distracting the army's attention from that over a minor satellite state?

It's time to take profits on Russia

As for investors well, Russia's got what it needed from them. It doesn't have to indulge them anymore. And that means that investors can no longer ignore political risk in the country. If I was you, I'd take any Russian profits you've made off the table. The time will come to get back in, but it's not now.

"We didn't need this," one Russian fund manager reportedly said at the weekend. "It's not going to break the Russian economy, but war is bad for investor sentiment."

No kidding.

Turning to the wider markets

UK shares picked up a further 1% with the FTSE 100 index gaining 53 points to 5,542. House builders were in demand, with Barratt Developments jumping 24% after Polaris Capital increased its stake to 6.2%, Bellway climbing 7%, Bovis 10%, Persimmon 11% and Taylor Wimpey 14%. But miners dropped again, with ENRC losing 6% despite Kazakhyms (down 1%), raising its stake to 25%. Rio Tinto shed 2% and Ferrexpo 6%. In contrast, ITV gained 6% on bid hopes while Wolseley rallied another 13% on disposal hopes. For a full market report, see: London market close.

Shares in Europe were better again, as the German Xetra Dax advanced 0.7% to 6,610 and the French CAC 40 added 1% to 4,538.

US stocks continued to improve, with the Dow Jones Industrial Average gaining 48 points, or 0.4%, to 11,782, while the wider S&P 500 added 0.7% to 1,305, its first close above 1,300 since late June. The tech-heavy Nasdaq Composite gained 1.1% to 2,440.

Overnight, the Japanese market slid 127 points, 1%, to 13,304. But in Hong Kong, the Hang Seng tacked on 39 points, 0.2%, to 21,899.

This morning, commodity prices were weaker with Brent spot trading at $111, spot gold at $808, silver at $14.24 and platinum at $1,488.

In the forex markets this morning, sterling was trading against the US dollar at 1.9015 and against the euro at 1.2776. The dollar was trading at 0.6720 against the euro and 109.86 against the Japanese yen.

This morning the latest RICS report showed UK house prices falling again in July as the credit squeeze brought the property market to a "virtual standstill, with first time buyers rapidly becoming an endangered species".