A Summary of the Risks
Posted Nov 29, 2011
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 27th November 2011.
1. Europe's sovereign debt crisis
Of all the risks facing the global economy, the euro-zone's sovereign debt crisis has recently had the highest profile and the biggest effect on the financial markets. The most blatant outward signs of the crisis are the sharp rises in European government bond yields since early October and especially since early November.
Last week, the focal point was Spain. Due to a failed debt auction, the yield on the 10-year Spanish Government Bond surged to a new high.
As a percentage of GDP, Spain's government has a lot less debt than the US government. However, the market is saying that there is significant risk of a default by Spain's government and zero risk of a default by the US government. As explained before, the main reason for this apparent discrepancy is that the US government has at its beck and call a central bank that will always be willing and able to buy federal debt should the need arise. The Spanish government has no such unconditional support from a buyer with infinitely deep pockets.
Also of relevance is that while Spain's government has one of the lowest debt/GDP ratios in the developed world, the total amount of debt within the Spanish economy is comparatively high and the private sector is in big trouble due to the knock-on effects of last decade's real estate bubble. For example, the unemployment rate in Spain is around 22% and the unemployment rate for people in the 18-24 age group is around 45%. These are Great-Depression-like numbers.
2. The slowdown in China's economy could evolve into a collapse
Although the government's GDP numbers don't reflect it and will never reflect it, there is little doubt that China's economy is in recession. The latest piece of evidence in support of this view comes from HSBC's Purchasing Management Index for China, which declined from 51 in October to 48 in November (below 50 suggests economic contraction).
In response to the slowing of the domestic economy and the economies to which they export a lot of goods, Chinese factories have been reducing their labour costs by reducing wages and/or eliminating overtime work. Furthermore, workers who live from hand to mouth are not only seeing their incomes reduced, they are also seeing their costs of living rise thanks to the monetary inflation of the past few years. The deadly combination of a weak labour market and rising prices for the basic necessities of life is one of the inevitable effects of Keynesian economic policy.
And it isn't just the factory workers of China that are becoming increasingly disgruntled due to the economic contraction. In addition, there have recently been cases of irate purchasers of new apartments storming the offices of the associated property developers. The purchasers became irate after realising that property prices can go down as well as up.
Civil unrest will almost certainly intensify throughout China if the overall economy continues to stagnate or contract. This could prompt the central government to change tack and attempt to re-ignite the boom via accelerated credit expansion, but going down that path would lead to an even bigger inflation problem. A worsening of the inflation problem would, in turn, lead to greater civil unrest.
Interventionist economic policy always ends up putting the government "between a rock and a hard place" -- where, no matter what is done, it is no longer possible to maintain the illusion that things are going well. It looks like China's government is now in such a predicament.
3. The US recession
It appears, to us, that the US economy has been in recession for much of this year. However, we don't know when the recession will officially be said to have begun. We can't even be sure that the recession of 2011 will ever be officially acknowledged. If forced to make a guess it would be that during the second or third quarters of next year, the National Bureau of Economic Research (NBER) will belatedly confirm that a US recession began during the third quarter of 2011.
It's possible that the current US recession will turn out to be mild, but for two reasons this is not the most probable outcome. First, the policies of the Fed and the government have got in the way of the economy's attempts to correct the problems that led to the 2007-2009 contraction. Of particular relevance, a lot of valuable resources have been channeled into the banking industry in an effort to keep alive badly managed and parasitical institutions. Second, the economies of China and most euro-zone countries are likely to perform poorly over the next 12 months, creating an external drag to go along with the internal drag.
The strong possibility that the US economy will remain in recession for at least a few more quarters is a big risk for the US stock market, because it means that 2012 earnings are likely to be a long way below the current forecasts of most analysts.
4. Egypt heating up, again
Many thousands of people flocked to Cairo's Tahrir Square over the past week to protest the slow pace at which the Supreme Council of Armed Forces (SCAF) says it will cede power to a civilian government. Clashes between the protestors and "security forces" led to the deaths of more than 40 protestors. SCAF apologised for these deaths, but refused to yield to the protestors' demand for a much quicker handover of power. This refusal makes it likely that protests will continue and tensions will escalate over the months ahead.
Elections for Egypt's Lower House of parliament are scheduled to commence this week. The problem, from the protestors' perspective, is that the elections will run for several months and even when they are complete the military will still be in charge. This is because the Lower House will have no real power anytime soon. Its primary role will be the writing of a constitution.
SCAF's current plan is for the transfer of power to a civilian authority to wait until after a president is elected, which won't happen any earlier than the second half of next year and will possibly not happen until 2013. Many Egyptians are worried that it will never happen.
The Muslim Brotherhood, the most important political party in post-Mubarak Egypt, chose not to get involved in last week's protests. This is no doubt because it is poised to do well in the coming elections and doesn't want to 'upset the apple cart'. However, the Brotherhood's tactics could change if its current lack of open support for the protests leads to a significant reduction in its popularity or if there are further delays to the handover of power.
The upshot is that the political situation in Egypt remains unstable and stands a good chance of becoming even more so in the near future. This adds to the growing pile of risks that the global financial markets have to deal with.
5. Other problems/threats in the Middle East
The Middle East is never a bastion of stability, but right now it appears to be even less stable than usual. For example, in addition to Egypt's increasingly-volatile political situation:
- There is a realistic chance that protests against the Assad regime in Syria, which have prompted a draconian and deadly response from the regime, will evolve into a full-blown revolution. Given President Assad's apparent commitment to retain power regardless of the human cost, the death toll would be huge.
- There is the ever-present threat that Israel and/or the US will take military action to derail Iran's nuclear program. The closer Iran gets to the point where it is able to build a working nuclear weapon, the more likely an Israeli-US attack becomes.
The situation in the Middle East is the most plausible explanation for why oil has begun to diverge from the stock market (the oil market has recently been much stronger than the stock market).
6. Quantitative Easing
The Fed's Quantitative Easing (QE) was one of the reasons that the US economy's rebound from the 2007-2009 recession was so weak. QE, or money printing to use a more descriptive label, doesn't create new wealth. Rather, it surreptitiously redistributes existing wealth. Some people end up poorer and other people end up richer.
Importantly, the wealth transfer is inefficient and tends to benefit the least productive and least prudent people at the expense of the most productive and most prudent. It therefore doesn't only reallocate the pieces of the pie, it makes the overall pie smaller. QE is a seductive policy, though, because it usually makes things look better for a short while
When a theory consistently fails in practice, a reasonable person will acknowledge the likelihood that the theory is wrong. However, it hasn't yet occurred to the Fed's leadership that QE theory (the theory that the economy can be helped by creating money out of nothing) is wrong. Consequently, there will very likely be more QE if the US economy gets worse and the stock market continues to trend downward.
The potential for a lot more QE is, in our opinion, the biggest risk facing the US economy. Moreover, this is a risk that will almost certainly materialise at some point. The only question is when.
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