Forecasting the Reckoning

ICangles Investment Post…

There has been a lot of worrying in financial markets over the past few months. In fact quite a long list of looming disasters has been assembled. Will destabilization in the Middle East, especially if unrest reaches Saudi Arabia, send oil prices skyrocketing and the global economy spiraling? Could this wave of unrest spread to China? Will the earthquake in Japan trigger a financial crisis in that country, as more debt is added to an already formidable mountain of debt? Is Bill Gross signaling a debt crisis in the U.S. is eminent, as he pilots the world’s largest bond fund out of U.S. Treasuries? Irrespective of the U.S. Treasury market is a wave of defaults on its way in the municipal bond market? And what about real estate—are we now on our way to a second bottom with prices headed for a 20 percent or greater decline?

I myself have contributed to this list of concerns warning about U.S. bonds, emerging market stocks, Chinese real estate and commodities being at risk of asset inflation, and the U.S. unemployment situation and economic growth situation being worse than the official numbers indicate. But, although I certainly wouldn’t argue that all the worries being lately discussed are groundless, I would advocate that serious financial market risk lies more in our future than present.

To understand why I am more concerned about financial market risk and a bear market for stocks in the future than the present year it is helpful to understand the common thread linking most of these worries. That thread is government money creation and spending—largely emanating from two central players in the world’s monetary system, the United States and China. The relationship where the U.S. sells debt to China and the Chinese in return sell all manner of products has been coined Chimerica. Unfortunately, ever since the residential real estate bust in the United States, Chimerica has slowly been unraveling.

Even with China subsidizing U.S. debt and by extension lowering borrowing rates, U.S. housing prices couldn’t go up forever and American consumers couldn’t keep buying things, including a lot items manufactured in China, based on the temporary wealth from home price appreciation. That party ended. However, the Federal Reserve decided problems created by too much cheap money could be solved with more cheap money, and as a result the U.S. government engaged in among other policies that of quantitative easing—a fancy word for injecting trillions of new dollars into the financial system as the U.S. government bought its own debt by basically printing the money. And expansionary fiscal and monetary policy has directly led to many of today’s worries.

Rising energy and food prices are not just signs of inflation, but are also likely a spark helping to set off the current wave of protests. Egypt certainly already had instability issues, as an aging dictator looked to pass power to a son with no claim to legitimacy, yet having a large part of the population in a poor country already struggling to get by pushed to the economic edge, as they were forced to find money they didn’t have to pay for higher food and energy prices, wasn’t helpful. Unfortunately, pressure on countries with stability and legitimacy issues is only likely to grow as inflation gathers strength.

On the other hand the nature of the situation in Egypt is a big reason to not be too concerned about instability in Saudi Arabia. That country doesn’t have similar political legitimacy issues (the dry tinder), nor does it have the same exposure to rising food and energy prices creating greater poverty (the spark) since it is a major energy exporter. Now if oil prices were to crater that might be reason for Saudi Arabian concern, but I would argue that even if we are in the midst of an unsustainable rise in the prices of some commodities, any crash is still a ways away and the near-term risk is more around inflationary price rises, which are not a problem for the Saudis.

Of course if as is the case of Libya a government has succession and legitimacy problems like Egypt, and despite being a commodity exporter doesn’t take aggressive policies to alleviate the impact of higher prices on basic items, as the Saudis did, it may be in trouble. But none of this really applies to another worry on the list—Chinese instability. I have plenty of concerns about China’s stability when the world’s current bad debt and cheap money bill comes due. But with their economy currently growing thanks in no small part to Chinese government led-spending and loaning activities that particular linchpin of the global monetary system appears solid for the time being.

In the case of Saudi Arabia and China, economic growth is helping buy political legitimacy and stability, despite inflationary pressures. All that cheap money being pushed into the global economy via Chimerica (expansionary monetary and fiscal policies out of the U.S. and China) is creating economic activity, just as the dotcom bubble and residential real estate bubbles initially created economic activity. And growth forestalls the day of reckoning. In the case of the residential real estate bubble it wasn’t until home prices started to decline that serious problems in the credit markets and in financial institutions, like AIG and Lehman Brothers, rose to the surface.

And that is why I’m not overly concerned about a default tsunami in the municipal bond market now. Yes, a lot of state and local governments have lousy finances, but as long as the economy keeps growing most will get by. The time to worry is when the next recession rolls around. Mix lousy finances with decreasing tax revenues and rising costs around programs, such as unemployment insurance and food assistance, and then there will be reason for concerns over widespread defaults. Chances are there also won’t be a Federal government bailout for the states next time or aggressive Federal Reserve monetary expansion. The same goes for the residential real estate market. I’m not losing sleep over an imminent steep decline in prices, but when the next recession comes there is a lot of reason to worry as we could see growing unemployment coupled with rising borrowing costs, due to inflation, hit home prices hard.

Based on all of this I have zero interest in being a long term holder of either Japanese or U.S. government debt, despite believing a debt crisis for either government is no more imminent than is one in the municipal bond markets. The finances of all look far from good and there are real inflationary pressures building in the world. U.S. bonds are likely already at the beginning of a long-term secular bear market, but there are no signs of a looming meltdown right now. As for emerging market stocks, commodity prices, and Chinese real estate, despite risks for all, right now only Chinese real estate checks nearly all the boxes for being in a true investment bubble. And Chinese real estate prices, as well as its economy in general, almost certainly have more room to run.

Inflation presently is not serious enough to force either the U.S. or China to hit the brakes on expansionary policies. And that is the key to all of this. When will Chimerica either be forced probably by inflation or proactively choose, in order to stave off inflation, to reverse cheap money policies. When that day finally comes it will then be time to worry about a long list of financial risks. The big question of course is when should investors get worried? Notwithstanding the general rule that one should always be vigilant, the calendar year 2013 stands out at the moment. In the United States market risk is often focused on the first two years of a presidential term, and 2013 will be the beginning of a new presidential cycle. That period is when odds are greatest for economically disruptive legislation to occur and conversely the last two years of a term are when such legislation is least likely.

In addition U.S. political pressure is typically at its strongest for expansionary fiscal and monetary policy just prior to a presidential election, such as the one that will be occurring in 2012. Turning to the second member of Chimerica, similar logic is also in play in China, where 2012 will see the National People’s Congress install the next generation of Chinese rulers. Political pressure in China will be extremely strong for expansionary economic policies to continue until after this leadership transition takes place. Of course markets sometimes move before events and conversely there is typically a lag between changes in economic policies and the impact. Yet at the very least 2011 should be a solid year for the economy and stock market. After that market risk will rise, with 2013 a year to pay special attention for signs of trouble.

 

UPDATE on June 13, 2011 Jim Juback in “The Coming Global Financial Crisis” articulated some of the same points around the timing of the next downturn.

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