As part of any investment acumen, anything outside of cash money markets, CDs and T-bills involves some element of risk. In the current market, there are what I would deem economic risks, geopolitical risks, natural disaster risks and pandemic risks.
Let’s identify which factors yield-seeking investors need to be consciously aware of, and why they’re so dangerous.
The Specter of Rising Inflation
The most prominent risk to income investing is inflation and how the Fed reacts to it in the form of the raising of interest rates.
At present, inflation is running at an annual rate of roughly 2%, a number the Fed and the markets can comfortably live with. Any rate above 3% and Fed policy will likely tighten, sending bond prices lower and bond-equivalent asset classes lower, as well.
Secondly, if the economy picks up growth in excess of 3.5%-4% for two or three quarters in a row, the Fed will be moved to ratchet rates up higher. Growth is good for all asset classes. However, too much growth brings about fear of a rapid increase in bond yields to compensate for a Fed that has kept rates artificially low. To combat that, I like to maintain a basket of holdings that focus on floating-rate debt and adjustable-rate mortgages, so as to profit from this environment.
Trouble Abroad — Or At Home
Natural disasters happen all the time all over the world. The extent of their impact and the particular regions they affect will determine the level of risk to one’s high-yield portfolio. Take hurricane Katrina, for example. The storm rippled through the U.S. economy on several levels, causing:
- massive interruptions in refined fuels, chemicals and the free flow of goods on the Mississippi River
- a huge spike in oil prices from the shuttering of offshore platforms in the Gulf
- disruption in the home and working lives of millions of people.
And, as we have all been witness to this past couple of weeks, geopolitical risk can derail a perfectly good stock market rally as violence (like the Sept. 11 attacks), sanctions, interruptions of goods and services and the threat of far-reaching economic implications take hold on investor psychology.
Sanctions on Russia would definitely impact Europe’s economy as the exposure would reach several industries and markets. That’d be a good time to own U.S. energy plays, which will be one of few companies that would be able to fill the gap should eurozone nations need to look outside of Russia for their oil and gas supply
Fears of Mass Disease Outbreaks
Lastly, there is pandemic risk in the form of a disease that spreads out of control. As of last week, the World Health Organization issued a emergency warning about the possible spread of the Ebola virus that is morphing into an epidemic in Africa.
One infected person on a flight to Europe or the United States could have devastating effects on the populations before being contained. Bird flu was the last virus to cause a similar stir, but not before vast numbers of people stocked up on Tamiflu and Relenza.
Three Problems Are More Dangerous Than One
Global markets can typically handle isolated bouts of each of these kinds of external risks, limiting the downside damage to most asset classes. However, when several of these kinds of risks occur simultaneously — as was the case last week — it can weigh heavily on investor sentiment.
Possible genocide in Iraq, a broken truce in Gaza, the threat of Russian invasion into Ukraine and the danger of importing Ebola into U.S. borders had investors on edge until headlines broke that these threats had been dialed down. What we all need to be aware of at this time is that, though these risks have all been diminished for the moment, they still are very prevalent and are not to be treated with complacency.
As long as there is risk to our hard-earned capital, it’s wise to stay informed on all that can negatively impact it.
Bryan Perry is the editor of Cash Machine, a newsletter focused on high-yield income investing with the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income, which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.