Why investors should plan for hard times

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: sign up for Money Morning

The Dow Jones Index hit a fresh all-time high yesterday, closing at 12,622, as the Federal Reserve kept interest rates on hold at 5.25%.

The accompanying statement suggested that all was well with the world. Growth is set to remain strong, while inflation will fall back, says the Fed. What's more, the US housing market is stabilising, say Ben Bernanke and the team.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

We'll take a more in-depth look at the US in a future Money Morning - but for the moment we'd like to turn our attention back to the good old UK, where the outlook is not quite as cheerful...

The Federal Reserve might be trying to spread good cheer in the US, with its view of the Goldilocks economy, but over here in the UK, our financial watchdog is feeling twitchy.

The Financial Services Authority has just published its Financial Risk Outlook for 2007. It turns out that there are a lot of risks out there, which is par for the course - but the trouble is that no one's paying any attention to them.

'Investors are mis-pricing risk premia and underestimating the uncertainties associated with geopolitical risk and tightening financial conditions,' says the FSA. And as Ambrose Evans-Pritchard points out in The Telegraph, if something does happen to shake investors out of their cosy inertia, the impact will be worse than say, two or three years ago. Why? Because 'global imbalances have continued to widen, whil investors' willingness to take risks has increased. Even a modest deterioration in the economic environment could have disproportionate effects on financial markets,' the FSA says.

The trouble is - as we've been discussing for a long time now - that cheap money has seen almost every asset class in every region push higher in unison. Investors 'think they are diversified but they are taking on crowded trades... the ripple effect of a localised event could spread to many different financial markets. This could lead to crowded exits, draining liquidity from the market and causing erratic price swings in commodities, emerging market equities and debt, and high-yield debt,' said the report.

What does that mean? Basically, one relatively small shock - such as a South American country defaulting on its debt, for example - could send investors running for the exits across a series of apparently unrelated markets, particularly risky ones like emerging markets and junk bonds. If they all flee at once, sellers will vastly outnumber buyers, sending prices plunging, and so kicking off more panic. And of course, most of these things are bought with borrowed money - so investors won't just be losing their own money, their creditors are likely to lose out too.

What are the big worries? Well, there's the old classics like a bird flu pandemic, an oil spike, a dollar collapse, or a war - but it's not just the big baddies that the FSA is fretting about. There are also the 'slow-burning risks'. Life has been easy for financial markets for a very long time - most bull markets are now looking long in the tooth, but investors have thrown caution to the winds. There is now far more leverage (borrowing) in the system than ever before. When a downturn comes, the ability of the global financial system to cope with the fact that some people will default on their debts will be tested for the first time in such conditions.

So should we be concerned? Well, yes, frankly. The FSA is right to be pointing these things out. Life is steadily getting tougher for those who are heavily indebted - home repossessions jumped by 65% last year, according to the Council of Mortgage Lenders. That might be from a low base, but it's heading in the wrong direction. The average debt level has hit an all-time high of nearly 140% of income - that's twice what it was in the 1980s.

As the FSA put it: 'In spite of the benign environment, there are growing signs of consumer distress, such as record levels of insolvencies, late payments on credit cards and a rise in mortgage-possession orders.'

The trouble is, of course, that timing these things is impossible. Life is good until it turns bad, and then it tends to turn from bad to worse very rapidly. So what can you do? Well, the simple answer is - don't overstretch yourself. Make sure you have a cushion so that if your personal economic circumstances suddenly get worse, you're not left holding an interest-only mortgage that amounts to six times your annual salary on a house with no equity in it. As Petter Tutton of Citizens Advice tells The Telegraph: 'Anyone taking out a new mortgage should check very carefully whether they can afford it if interest rates rise.'

Sometimes you can afford to take risks in life - and the best time is usually when everyone else is at their most risk-averse. But when the crowd is ploughing ahead as if there's no news but good news, and nothing but glorious sunny days ahead, that's when you should be planning for rain.

Turning to the stock markets...

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email

In London yesterday, the FTSE 100 closed 38 points lower, at 6,203, as strong gains for steelmaker Corus failed to offset weakness in the insurance sector. Friends Provident was the day's biggest faller due to a worrying update from F&C Asset Management, of which the insurer owns 52%. Peers Royal and Sun Alliance and Prudential fell in sympathy. For a full market report, see: London market close

On the Continent, the Frankfurt DAX-30 closed flat at 6,758, whilst the Paris CAC-40 ended the day 37 points lower, at 5,608.

Across the Atlantic, the Federal Reserve's decision to keep interest rates steady and suggestions that inflation was under control boosted US stocks. The Dow Jones enjoyed its best day of the year so far, gaining 98 points to close at 12,621. The S&P 500 ended the day at 1,438, a 9-point gain. The tech-heavy Nasdaq, meanwhile, gained 15 points to end the day at 1,463.

In Asia, the Nikkei tracked Wall Street gains, closing 136 points higher, at 17,519.

Crude oil had pulled back slightly from yesterday's gains today and was trading 31c lower at $57.83 this morning. In London, Brent spot was at $56.78.

Spot gold hit $654/oz yesterday - its best level since August 2006 - but had fallen back to $652.60 this morning. Silver had climbed to $13.52.

And in London this morning, oil major Royal Dutch Shell posted a forecast-beating 2.6% rise in underlying fourth quarter profit due to stronger production and firmer oil prices. Royal Dutch Shell's shares had climbed by as much as 1.8% today.

And our two recommended articles for today...

Commodities: a bull or a bubble?

- Are commodities in a long-term bull market driven by emerging giants such as China? Or is it just a bubble? MoneyWeek's John Stepek and Cris Sholto Heaton both argued their respective viewpoints in this recent cover story, now available to non-subscribers. And if, like John, you're still a commodities bull, we have three solid stock tips for you: Commodities: a bull or a bubble?

Three global economic trends to watch

- The annual Morgan Stanley forum on the global economy, MacroVision, concentrated on three economic trends this year: liquidity, commodities and protectionism. For Chief Economist Stephen Roach's take on proceedings, read: Three global economic trends to watch