We’re now entering a long economic cycle where the management of energy input costs will determine who wins and who loses, writes Eddie Hobbs.

Important parts of the Irish economy already appear to be in retreat, even if economic indicators haven’t yet fully measured the impact. We knew all along about US sub-prime debt and how the dollar was floating on an ocean of trade deficits, current account deficits and consumer debt - but as long as the engine room of the world economy produced its growth magic, the rest of the world bought in.

Fearing a dollar freefall, two years ago I advised offloading US assets and promoted buying gold as a hedge. However, I’ll admit to being blindsided by the speed of these events and the harsh impact on investor confidence at home.

Our desire to control and predict blinds us to the uncomfortable prevalence of improbable and huge events that defy our best-risk models. No sooner does the event happen than we rush to make it appear less random and more predictable.

Globally, 9/11 was such an event but, locally, at the apex of the Tiger, trust and confidence have been greatly undermined by many things: the visceral image of the Irish middle classes queuing outside Northern Rock; disturbing stories about high profile solicitors; and - as if to copperfasten our anxiety - the halving of Irish bank values.

Even if they are oversold, bank shares will now require a 100 per cent bounce to reach previous highs. Nobody foresaw such a swift reversal of fortune.

The great double bet on Irish housing and banking, which ignored the principle of diversification elsewhere, has gone sour in jig time. Wealth is being shed at a rapid rate.

Just like all bubbles, I suppose there’s a tipping point, and large-scale defaults in dodgy US mortgages, costing somewhere between $50 billion and $300 billion, called time on an addiction to easy credit. But what seemed a localised event has infested global banking with the worst type of malaise - a lack of confidence in lending.

Optimists believe this will pass in quarter-one next year, as results for the second half of this year are reported - but optimists are thin on the ground. In the absence of facts, perception becomes reality and, right now, the prevailing mood is overwhelmingly pessimistic.

Nobody can yet accurately assess the harm being caused as liquidity dries up for over-borrowed investors, from racy hedge funds to Irish landlords and consumers, already overstretched on credit.

Suddenly, debt is beginning to feel heavier, as the old escape routes, such as tax cuts and higher salaries have become less certain. On Wednesday, a real test of leadership arrives when Brian Cowen delivers the Budget. Will he inject badly needed liquidity into the economy by cutting taxes and stimulating investment, or will he mimic government rhetoric, play safe and emulate Nero? We’ll know in three days.

The pain starts
Debt-distressed sellers are already cutting property prices by up to 30 per cent as Irish economic growth cools rapidly.

The mood, fragile from a stagnant property market over the past year, has deteriorated in just a few months, in a country so reliant on liquidity to finance consumer spending and investment. The chill wind of the credit squeeze is now under way in the developer sector.

Payments to suppliers are being staggered, some are delayed indefinitely.

Serious cash is tip-toeing away from deposit-takers perceived as more vulnerable, against a backdrop of rumour and conjecture.

Chasing lower default risk has suddenly become more important than chasing yields for everyone, everywhere. It’s as if a great washing machine has slowed to a halt.

Projects are on ice. Exuberant investment confidence has shrivelled away like a dried out raisin as anxiety takes hold. Fund-raising has ground to a halt and is likely to stay that way well into next year.

If I were launching anything today, it would be a brand of sleeping pill and not a complex financial product such as Brendan Investments, because sentiment will take time to recover, even when current difficulties are resolved.

Still, short-term speculators remain. One hardy soul told me this week he’d put a large deposit on three eastern European apartment blocks, hoping to flip them in January. He did so without bank finance in place to finish out.

Speculators who hold British flips - deposits on multiple properties bought off plans and hoping to sell on without holding long term- are also facing a wipeout.

The properties are worth less than the contract price, aggressive lending is dead, and failure to complete will trigger legal action.

Reported here in The Sunday Business Post by David Clerkin, Irish developers are fooling nobody by turning landlords and swapping short-term development debt for long-term investment mortgages.

This is a book-keeping exercise encouraged by banks hoping to massage year-end figures but, for developers, it’s as unnatural as turning up at a fox hunt on a camel.

The darker mood may already be spilling over into consumer spending, judging from the low turnout at recent consumer exhibitions.

What strategy to follow?
Any new strategy has to deal with the tension between the short-term speculative moves and long-term investment. In the short-term, there is likely to be a series of Fed-led rate cuts to stave off aUS recession.

It may not be successful, but it is likely to be followed by ECB cuts protecting European export competitiveness. The problem is that cutting rates runs contrary to classic Central Bank thinking, at a time when energy and commodity inflation looks pretty certain.

The world may be entering the greatest transition since industrialisation, as the cheap oil age ends. This trend should inform all decisions in my view, including short-term plays.

We’re entering a long economic cycle where the management of energy input costs will determine who wins and who loses. Despite volatility, oil (and gas) prices are set to rise much higher than $100 per barrel. This is easy to figure out if you accept that maximum production is between 90million and 100million barrels a day and current demand, growing at 4 per cent yearly in non-OECD countries, is a fraction behind, at 86 million barrels a day.

There is not going to be a soft landing between the days of cheap oil and the new energy age. Better instead to expect a stormy transition to the post-oil age with energy and commodity-led price spikes leading to volatile economic cycles, while vast fortunes are made by businesses on the right side of the energy issue.

In one sense, this should be welcomed, as it is a by-product of world economic success and population quadrupling over the past 100 years.

The race for alternative energy sources and breakthroughs in energy efficiency technologies not only will assist in tackling carbon dioxide emissions but should spark a new type of economic growth.

Screening assets
While thinking defensively in the short-term, it’s still best to screen all your decisions on assets, funds or stocks, based on their positive or negative positioning to high inflation and energy costs.

The experience of the 1970s, marked by shortages of oil and other resources - and by massive increases in government spending - helps throw grit on an otherwise slippery road. Despite current events, it is less risky to stay with good assets through thick and thin, rather than switch out to safe havens and, jangled by nerves, miss the inevitable bounce from oversold sectors.

Over-concentration in cash and bonds cost investors dearly in the 1970s, shedding between 10.5 per cent and 17.5 per cent of real value in the US.

Gold bullion, however, grew by over 880 per cent. Declining confidence in the dollar and rising inflation is fertile ground for another prolonged gold bull market. You can buy gold in the form of Perth Mint certificates or as an Exchange Traded Fund such as Lyxor Gold Bullion securities quoted on the LSE.

Residential property mortgages that rely on jobs in local economies vulnerable to substitution from lower-cost countries are at obvious risk to long vacancy periods. High inflation, while boosting the price of property, reduces the real burden of underlying debt.

Property, unsurprisingly, is a good inflation hedge, but timing and market choice is crucial, especially after a prolonged rising cycle in many countries and the beginning of a bruising credit crunch. Certainly, for the next few years, investors are best advised to concentrate on high rental yields that cover borrowing costs with room to spare and are, ideally, inflation linked.

That’s why German commercial looks attractive relative to lower yield and fully priced markets. Irish residential rental yields, lagging the risk-free rate of return from cash deposits, were always set for a correction.

Rent inflation is part of sorting out the imbalance, but so too are the continuing price falls predicted for next year. Cash-rich buyers will mop up the wealth lost by distressed sellers once the market returns.

Index tracking, a favourite strategy in general equity investment which doesn’t differentiate between large companies and invests purely on scale, may struggle. Guaranteed bonds linked to these indices and that feed on nervousness, are likely to flood the market again shortly.

But in the 1970s, the S&P 500 shed 14 per cent in real money terms, and some sectors took a hammering: cosmetics lost 45 per cent, retail stores 34 per cent, airlines 37 per cent, autos 55 per cent and chemicals 47 per cent.

The groupthink that continues to deny the scale of the energy challenge does not bode well for the speed at which ‘‘managed’’ and ‘‘consensus’’ funds, which covertly and overtly copy one another, will get the message. These are the common fare for pensions.

Small caps did well in the 1970s, but will be handicapped this time by lack of exposure to fast-growing Asian markets, which you should look for in any growth stock.

In the 1970s, crude oil topped 470 per cent and, unsurprisingly, oil service companies grew by over 700 per cent, so this time around, investment in those controlling conventional energy sources should do well - but investments in scalable alternative energy should do even better.

Since the problem is choosing the big winners from nuclear, tar sands, liquefied natural gas, bio-fuels, wind, solar, tidal and synthetic fuels, the best approach is to opt for well-spread funds rather than stocks.

The retail fund market is still thin, but JP Morgan’s Natural Resources fund, which invests in oil, gas and metal mining including gold, is interesting, as is New Ireland’s newly opened KBC Alternative Energy Fund.

The drive towards energy efficiency and lower carbon emissions is creating new economic growth in sectors and businesses positively exposed to these forces, with Europe showing leadership in regulatory pressure. Semiconductors that improve efficiency are poised for strong growth, as are building insulators such as Rockwool and Kingspan.

Capital goods businesses, such as Siemens, Electrolux and Daikin (which are dominant in energy-efficient air conditioning) should do well. In autos, companies such as Toyota are leading the field on hybrids. There’s a lot of growth in businesses ahead of the game in energy efficiency, but the real money will be made by those that crack clean-coal technology and relieve the US and China of their swingeing carbon emission costs.

Early breakthroughs are possible, including a pioneering enzyme treatment that promises to change ash to a useable building product. What the retail market needs is fund choices that plug into players such as Merril Lynch to take the guesswork out and give investors a diversified mix of leaders in energy efficiency.

Embrace risk and change
So, while dark clouds are gathering, there is reason to be cheerful and to continue to invest in confidence.

There’s no ideal mix. Much depends on where you’re starting from and switching costs, but one thing is clear, new thinking about diversification and a willingness to change and to take risks is needed to get the most out of the times ahead.

Expect even more volatility in the future, with larger peaks and troughs. The trick is to get used to it, to dust yourself down and stay focused on the long-term.