If Australia and China are entering the final phase of their credit booms, many Australians will be inadequately prepared for the consequences.

In November last year I published Taking the market's temperature, which used the framework laid out by Howard Marks in his excellent book The Most Important Thing to take the pulse of the market and help determine what action we should be taking with our portfolios. Marks acknowledges the difficulties of judging where financial markets and economies might be headed, but I agree with him that it's a very good idea to at least get a feel for where we are currently to help guide your decisions.

I won't rehash the analysis in this blog post, but instead I wanted to highlight this chart from the financial boffins at SocGen that provides an overview of the world's major economies and where they currently fit in the 'Global Leverage Cycle'. In a simpler form you might recognise this as an 'Economic Clock', and it's a useful input for Marks' framework.

I generally include any economic analysis as just another factor in analysing a business and its industry, but it's hard to ignore China's and Australia's position on the chart. China's credit boom remains in full swing despite attempts from the authorities to rein in lending and control house prices. Credit growth in September 2013 alone was reportedly US$230bn. For the year up until September 2013 the figure was US$2.3trillion, a 20% increase on the record growth in credit in 2012.

We've been preparing our model portfolios for a (rapid) slow down in China's economy for two years now, mostly by buying businesses with large overseas divisions to take advantage of a lower Aussie dollar and by avoiding or reducing our exposure to highly priced businesses that are highly leveraged to a strong Australian economy, such as the banks. I don't know whether 2014 will finally be the year that China's incredible run leads to a potentially painful 'adjustment', but I doubt most Australian investors will be adequately prepared for it when/if it happens.

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