As countries worldwide gradually post positive economic news, investors here are asking advisors when they can expect a sharp up-tick in returns.

It’s a fair question, but a tough one for advisors to answer.

While China may achieve a soft landing and the U.S. appears to be getting back on its feet, there are still plenty of reasons why recovery levels around the globe remain anemic. And there’s a potential tiger in the smoke in the form of the instability of European sovereign debt.

Bailouts are never positive, and the number of European countries accepting loans has some pundits asking why Europe’s market regulators aren’t coming clean on the fact that much sovereign debt from the region is starting to take on the characteristics of a toxic asset class.

The answer, of course, is that regulators are ultimately controlled by governments, and so are reluctant to spread news that will trash the value of the home team’s currency.

Many investors here, though, make the mistake of assuming the risk is concentrated in Europe, and particularly in France and Germany, since those countries have the most to lose if their Euro Zone counterparts default. But nothing could be further from the truth.

Three years ago, people were opining that risky U.S. real estate loans would only hurt the host economy, and could be diversified away within a well-structured portfolio or product. That logic proved faulty.
Given the fragility of the recovery, a ticking bomb in any geographic region or financial sector presents a threat to investment markets worldwide. A bond implosion in Europe could send interest rates skyrocketing worldwide, invert the yield curve and drive current bond holdings through the floor.

Not the best news, since Canadian investors are, on balance, selling off equity-based funds and taking refuge in the fixed and guaranteed income fund space, and in precious metals. According to The Investment Funds Institute of Canada, there has been more than $11 billion in net inflows
into bond funds in the last 12 months.

Right now, interest rates are at historical lows, which means that—unless they stay in the trough—they have nowhere to go but up. When they do rise, and it is a question of when and not if, the bond market will face a decline in value.

Of course, inflation’s no friend of equities either, as it tends to ding corporate profits and stock prices—and make it harder for companies to borrow funds to grow their operations.

Not every client will be interested in the economic nuances; they simply know they’re tired of less-than-exciting returns and long for boom times to return. It falls to you to keep them realistic and do everything you can to ensure they’re not overexposed to the risks that will emerge as interest rates rise.

Originally published in Advisor's Edge

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