How To Prepare Your Portfolio For A Spike In Long-Term Interest Rates

by: BubbleBustInvesting

In a piece we wrote some time ago, we argued that the U.S. economy was about to enter Japanese style prolonged stagnation. A spike in long-term interest rates that began in South Europe last year, and now is spreading to Northern Europe and eventually to the U.S., raises the prospect of a worldwide recession rather than a prolonged stagnation — half of Europe is already in recession, while the remaining is growing at a flat rate; Japan continues to flounder in the swamp of stagnation; America is barely growing; China’s manufacturing is slowing; And even Brazil’s growth has come to a standstill.

What makes this scenario particularly worrisome is that policymakers in U.S., Japan and Europe have already exhausted both their monetary and fiscal ammunition to avert or even cushion the repercussions of such a scenario. So, what should investors do?

A recession is normally bad for the overall equity (especially cyclical stocks) and commodity markets; and good for fixed income markets. But with interest rates at record low levels, things aren’t that simple. Here are five trades investors may want to consider:

1. Sell high-flying cyclical stocks. For more than two years, commodities had everything going their way. This is especially true for materials and precious metals: ultra-accommodating monetary and fiscal policy, a falling dollar, a growing world economy, inflationary expectations, and soaring sovereign debt. Walter Energy (WLT) that missed on second quarter revenues by a great margin is up 400 percent since 2009. Cliffs Natural Resources (CLF) is up 300 percent. iShares silver trust (SLV) is up 150 percent since early 2009; SPDR Gold Shares (GLD) is up 98 percent; and Freeport-McMoRan Copper and Gold (FCX) soared 300 percent. But with rising long-term interest rates and the world economy sliding into recession the commodity rally is over; and may be succeed by a bear market.

2. Be Selective on Chinese stocks. A global recession will slow-down for Chinese products, and may even intensify trade tensions between the two countries. Besides, as we discussed in a previous article, buying Chinese companies traded in U.S. exchanges is a high-risk strategy, as these companies are subject to frequent changes in rules and regulations that undermine their ability to stay in business and maintain profitability. Smaller Chinese companies, especially those listed through ”reverse mergers,” are conducive to accounting fraud and manipulation. While I will stay with quality names Sina Corporation (SINA), Baidu, Inc. (BIDU), and Inc. (SOHU) that had good earnings reports, I will stay away from, Inc. (YOKU), E-Commerce China Dangdang (DANG), Renren Inc (RENN). and the likes that had missed earnings expectations.

3. Stay Away from momentum stocks. Momentum investing is a strategy based on hype about an investment theme, a new product or a new industry that captures and captivates the investor mind-- at times when money is cheap. In the late 1990s, the theme was telecommunications and networking, with momentum funds flowing into companies like Ciena Corp (CIEN), JDS Uniphase Corp (JDSU), Corning, Inc. and Ariba Inc. (ARBA). Now the theme is social media and web-based companies, like Netflix, Inc. (NFLX), Open Table Inc. (OPEN), and LinkedIn Corp (LNKD). Momentum investing can be very rewarding as long as it lasts. But it can result in hefty losses once it fades away, especially for investors who got in at the top.

4. Stay away from U.S. Treasuries -- and Treasury ETFs like TLT. Though U.S. Treasuries are the first investment to come in mind when the economy heads into recession. This time yields are already near record low levels, notwithstanding the impending downgrades by US. So any gains from these levels will be limited.

5. Buy non-cyclical stocks — stocks that fare better during a recession like food and beverage, but stay away from medical providers like nursing home companies, which are expected to be negatively affected by deficit cuts, as discussed in a previous piece.

Disclosure: I am short TLT, SLV, WLT, NFLX.