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Three investments for these risky times
May 14, 2011

Markets don't know which way to turn.

Take yesterday. China began the day by tightening monetary policy further. Investors went into full-on 'risk-off' mode. Commodities and other commodity-related assets (such as the Aussie dollar) duly tanked.

Then, later in the day, US jobless claims came in roughly as expected. And retail sales weren't too bad. So investors relaxed again. Back came 'risk-on' mode. Commodities bounced and the US dollar eased back.

What can you do as an ordinary private investor amid all this chaos? We have some suggestions.

Why investors are afraid of tighter monetary policies

China's central bank (The People's Bank of China) raised bank reserve requirements for the fifth time this year yesterday. The move came as a surprise and knocked the wind out of commodity markets.

Inflation worries investors because they think it means that central banks will raise interest rates or tighten monetary policy more vigorously. That'll mean slower growth. And that'll mean harder times for stock markets.

Worse still, this tightening in China comes as the Federal Reserve in the US is about to allow quantitative easing (QE) to come to an end. And that's definitely bad news for 'risk' assets.

Jamie Chisholm points out an interesting study in his column in the Financial Times this morning. The Bank of Tokyo-Mitsubishi UFJ (BTMU) has created an index looking at the performance of various assets to see whether investors are in a 'risk-on' or 'risk-off' mood. The index shows that the second batch of QE increased investors' appetite for risk.

However, now it is slowly in decline. Lee Hardman at BTMU says: "We believe that our index is potentially signalling that the prolonged period of risk seeking could soon be coming to an end coinciding with the end of QE".

It'll be hard for the Fed to launch QE3

So what next? Someone we quote regularly here is Jeremy Grantham of GMO, because he has a decent track record on the big calls. Up until now, he'd been suggesting that investors had until early October to milk what they could from 'risk-on' assets. But he's decided that - given how far the market had already come this year - it's time to "lighten up on risk-taking now".

The broad impact of the Japanese earthquake remains unknown. The upheaval in the Middle East could yet spring some nasty economic surprises. Add that to the end of QE, and rising inflation in developing countries, and there's just too many risks out there.

"A third round of quantitative easing would very probably keep the speculative game going. But without a QE3, there seem to be too many unexpected (indeed unexpectable) special factors weighing against risk-taking in these overpriced times."

The fact is, the Fed may pull QE3 out of a hat. But it'll need an excuse first. And as I mentioned a couple of days ago, QE is no longer an easy option politically. Federal Reserve chief Ben Bernanke certainly doesn't command the same level of adoration that Alan Greenspan once (undeservedly) did.

And little wonder. The voter in the street reckons that QE is little more than a handout for Wall Street. It hasn't helped house prices to stabilise in any obvious way. It hasn't helped them get jobs, or pay rises. And it has driven up the cost of food and fuel. When you put it like that, why would anyone want more of this money-printing nonsense?

Trying to point out that things might have been worse without it isn't easy if you're talking to someone who has lost their job and their home. 'Worse how?' might well be their response.

What to buy now

So I suspect that for QE3 to be announced, we'd need to see a pretty drastic collapse. And not in commodities, but in stocks, because that's primarily what Bernanke seems to care about. In other words, markets would have to fall a lot harder and faster than they have so far for the Fed to press the panic button on their printer again.

And I'd add a further risk - Galleon Group co-founder Raj Rajaratnam's being found guilty in the recent insider trading case. That means anyone in the professional investment arena, particularly in the US, is probably going to be feeling a little bit twitchy and paranoid. That doesn't make for a bullish trading environment.

What should investors do now, in that case? Grantham reckons you need to take a "hard-nosed value approach". Have "substantial cash reserves", "high-quality blue chips", and "emerging market equities" (my colleague Cris Sholto Heaton suggested a good way to play these in a recent MoneyWeek magazine cover story - you can read it here: Where to find growth - and income - in emerging markets.

Interestingly, GMO has also increased its exposure to Japan, which makes yet another smart investor who likes Japan

This article is authored by MoneyWeek, the UKs best selling financial magazine. MoneyWeek offers intelligent, easy-to-read analysis of the financial news, with practical investment advice.

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