Investors need to focus on their response to financial stresses in an era in which policymakers will be constrained.
The “everything bubble” is deflating. The fact that it’s happening relatively slowly shouldn’t blind us to the real threat: The world is dangerously underestimating how hard it’ll be to deal with the fallout once it pops.
Frothy markets can’t disguise the warning signs. The shift to tighter monetary policies in the West is putting pressure on global equity and real-estate values. Even more critically, it’s weakening credit markets. Over-indebted emerging markets face headwinds from rising borrowing costs and dollar shortages.
At the same time, investors are underestimating how disruptive trade conflicts and sanctions could turn out to be. That’s not to mention rising non-financial risks — from the legal difficulties of the U.S. administration, to the U.K.’s Brexit debacle, to political instability in France, Germany, Italy and even Saudi Arabia. Uncertainty will impact the real economy, primarily through the wealth effect of declining asset values and a reduced supply of credit.
Investors need to start focusing on how best to respond to a new crisis. The choices are more limited than many realize. Historically, central banks have needed to slash official rates as much as 4-5 percent in order to offset the effects of a financial crisis or an economic slowdown. That’s why former U.S. Federal Reserve Chair Janet Yellen talked about the need to raise rates in good times — to provide room to cut when necessary.
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