BY Jurrien Timmer, Director of Global Macro and Co-Manager of Fidelity^® Global Strategies Fund, Fidelity Viewpoints – 07/20/11

A hard-headed look at four key risks facing investors–with bullish and bearish scenarios.

Are you finding it tough to make investment decisions these days? Are the headlines too scary? I'd say 2008 was scarier by far. But today certainly feels like a close second. So many things look as though they could go wrong, possibly all at once, that it's no wonder it appears the investing public has "checked out."

The way I see it, there are four major risks facing investors today. There's the debt-ceiling showdown in Washington, the painfully slow jobless and housing-less recovery in the United States coinciding with the end of QE2, and inflationary pressures in China and the potential for a hard landing there. Then we have what I consider the "Big Kahuna" of event risks, the European debt crisis.

What are investors supposed to do? Buy the "safety" of cash, knowing that they may be potentially losing more than 3% of their purchasing power every year because of inflation? Buy Treasuries, even though the combination of high-debt loads, large deficits, and negative real rates could make for a poor value proposition, at least right now? Buy stocks, knowing that we may be only a few policy mistakes away (in Washington, Brussels, or Beijing) from a crisis? Buy gold, even though it has already run up to $1,600? Difficult choices, indeed.

In some ways, today feels like an echo of 2008. And for good reason, in my view. The credit crisis was about contagion emanating from the subprime crisis to the investment banks to the commercial banks to the corporate sector to the consumer. From my perspective, only TARP (the Troubled Asset Relief Program) and QE1 (the first round of quantitative easing by the Fed) stopped the bleeding in late 2008, and then China's fiscal stimulus got the global economy going again in 2009.

But now what? Here's my thinking on each of four major risk factors today¨Calong with possible implications for investors.

Europe's debt crisis

This time it's Europe's debt crisis that has the potential to go very wrong. I don't think it has to, but it would if policymakers make the wrong decisions. Let's hope they don't, for if they do, Europe's core may have undercapitalized banks to bail out, and not just to cover the debt of Greece, Portugal, and Ireland, but now also of Spain and Italy, where the contagion has been spreading.

At least in 2008 the Fed was on the case. The European Central Bank (ECB) is raising¨Cyes, raising¨Crates, and until last week, shrinking its balance sheet.

And China is now in its late cycle, trying to engineer a soft landing to bring inflation down. That suggests to me that China is not in any position to unleash a whole new stimulus plan like it did in 2009, when it was in its early cycle with plenty of monetary ammunition.

Leap of faith?
There are only two ways out, if you ask me. I don't think the "whack-a-mole" response, reacting to things as they arise, is going to cut it anymore. In my view, either the "troika"¨Cthe European Commission (EU), ECB, and International Monetary Fund (IMF)¨Cgets in front of this thing (by restructuring debt and buying back bonds), or the whole thing may unravel.

What to do? Call me an optimist, but I still am inclined to take the leap of faith that the troika will do what's needed. Policymakers in Europe have been indecisive for months, but there's nothing like a crisis to focus the mind.

What we really need out of Europe, in my view, is for the ECB to "loosen up" and once again expand its balance sheet by buying up peripheral debt. Fortunately there were signs that the ECB was doing just that last week. In addition, I believe ending the ECB's recent trajectory of rate hikes would be helpful, but asset purchases are more important in my opinion. So, there is some good news there, but we need more. We need a sustainable resolution so that the contagion ends.

Interestingly enough, China once again appears to be a white knight of sorts, only this time it's not in the form of infrastructure spending, but as a buyer of Europe's debt and a supporter of the euro. If you ask me, the last thing China wants to see is for the euro to disappear as a viable reserve currency, leaving only the dollar. So, buying Italian, Greek, or Spanish bonds may make a lot of sense, especially given China's $3.2 trillion in foreign reserves and its buying strike of U.S. debt.

All in all, I am hoping that policymakers do the right thing in the coming days to finally get in front of this thing. I think the "whack-a-mole" game has gone on long enough.

Possible scenarios
 

• Troika finds a solution through debt restructuring and buybacks, which I believe would be bullish for the euro, stocks, and peripheral European countries and bearish for German bonds.
• Troika doesn't find a solution, which I believe would be bearish for the euro and commodities, and bullish for German bonds and eventually bullish for gold as the ECB/European Financial Stability Facility (EFSF) may be forced to monetize their debt.

Debt ceiling

What about the debt ceiling? I am actually not that worried about this one. I just can't believe that our elected officials in Washington will allow the United States to default on its debt.

For me this is a question of what kind of deal will be cut and when. At this point, the two sides are so far apart that I can't imagine an austerity plan that cuts something like $4 to $6 trillion from the budget. More likely, I think it will be a $1¡§C$2 trillion deal over 10 years. Something that isn't too painful but that still sounds impressive. If that happens, I think the dollar could gradually erode, real rates remain negative, and stocks go up.

Possible scenarios

• A $4 trillion to $6 trillion austerity plan that could slow the economy while reducing the deficit. In my view, that would be bullish for Treasuries and the dollar (and eventually for gold if the resulting slowdown leads to QE3), but bearish for stocks and commodities.
• A $1 trillion to $2 trillion deficit reduction deal spread over 10 years. I believe this would be bearish for Treasuries and the dollar, and bullish for stocks, commodities, and gold (high deficits have meant that negative real rates persist).

The soft patch

What about the U.S. economic slowdown? The employment report on July 8 was dismal, and the Institute for Supply Management, (ISM) survey dropped from 61 to 53 in the span of only a few months. But from what I can tell, the U.S. economy could improve in the quarters ahead, if for no other reason than that at least part of the slowdown was caused by Japan's earthquake and tsunami, and things seems to be recovering strongly over there. That suggests to me that things could recover over here too.

And for those concerned about the end of QE2, remember that the Fed has more or less committed to keeping rates at zero and the balance sheet expanded for a long time. In my opinion, that is as powerful as any QE3, perhaps even more so.

Possible scenarios

• Soft patch ends and we go back to moderate growth, which I believe would be bullish for stocks, commodities, and somewhat for gold, but bearish for the dollar and Treasuries.
• Soft patch turns into a double dip, which I believe would be bearish for stocks and commodities, but bullish for the dollar, Treasuries, and eventually for gold if this ensures QE3.

China

And then there's China. My view is that it's too early to be bearish on China. Yes inflation is rising (reaching 6.4% in June) and there are lots of risks in terms of property and credit. Plus, the central bank is tightening and the economy is slowing. The risk of a hard landing is real when countries tighten, and in China's case a hard landing could have global repercussions, not only for itself but also its trading partners like the United States and Germany. A closed capital system creates the risk of misallocation of capital and that is certainly true for China. Hence, the potential exists that we could witness a bursting of both the credit and property bubble at some point.

The question is when. China is growing at more than 9%, and as long as growth continues at that pace, it is hard for me to see the bursting of any bubbles (if that's what they are). It may be like subprime mortgages in 2007. The problem became exposed only when home prices started falling and homeowners could no longer refinance. I think the same applies to China. As long as growth continues, any structural problems stemming from the misallocation of capital may be "papered over."

Possible scenarios

• Soft landing succeeds and China stops tightening, which I believe would be bullish for stocks, commodities, and gold, but bearish for the dollar.
• Soft landing turns into a crash landing and exposes credit and real estate bubbles. In my view that would be bullish for the dollar and Treasuries, but bearish for stocks and commodities.

My take

I have reasonably high conviction that we will get a "kick-the-can" down the road debt-ceiling deal, China will continue to grow (for now), and the soft patch will end in the United States. For me that would mean a weaker dollar, rising bond yields, and higher prices for stocks, commodities, and gold. What I don't have high conviction on is the European situation.

In other words, if we also get a solution in Europe, then I think it is even more bullish for stocks and commodities, and bearish for the dollar and Treasuries. If the European solution also includes debt monetization (which I think it probably will), I think it would be bullish for gold as well. But, if we don't eventually get a solution in Europe, then I believe all bets are off.

Given the high stakes as these risks play out, the markets could be quite volatile over the coming weeks. So, it's important to have a financial plan that is in synch with your risk tolerance and time horizon. Keep your eye on your long-term goals. And if your plan is solid stick with it.