I.C. Angles Investment Post…
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” — Donald Rumsfeld, Former U.S. Secretary of Defense
Greece and China have both been in business headlines in June, reminding me of Donald Rumsefeld’s famous quote about known unknowns. It is widely known that Greece may exit the Euro, and as I write this column news has broken that Greek banks will be closed on Monday and capital controls imposed in the country in response to the deepening crisis. It is also known that in response to a slowing economy and recent two week selloff in its stock market, the Chinese government has cut its benchmark lending rate to a record low and is pursuing increasingly accommodative policies. Those are the known knowns.
The Unknowns of Grexit
I do a lot of reading and research around the global economy, and I am struck with just how much is unknown about both Greece and China. Greece exiting the Euro has been talked about for so long that there is even a name for it “Grexit”, but I can’t tell you the financial repercussions of such an eventuality. The best case scenario is one where a relatively insignificant economy such as Greece turns out to have a negligible impact. The worst case is the contagion scenario where credit markets in the Eurozone and beyond cease to function efficiently in quick succession, as risk aversion rises due to fears that other Eurozone countries, such as Italy or Spain, face a similar fate. Maybe it will be something in between. No one really knows, which is why the negotiations resemble a big game of chicken, where both sides are afraid of the unknown and trying to force terms on the other by taking advantage of their respective fears.
My own opinion is that the Euro as we know it is doomed, because it is substantially based on poorer countries like Greece buying imports from and selling debt largely to the Germans. And we are now at the point, where that arrangement is no longer viable. The Germans have made clear they aren’t going to continue to lend money, unless there are enforced austerity measures agreed to and undertaken by the Greeks to cut spending and service their debt. The Greeks and increasingly also other indebted European citizenries are making clear they will not accept meaningful cuts in their services, in order to pay off debt holders. Nevertheless, politicians are very adept at postponing days of reckoning, and I have no idea how long half measures can continue to postpone the inevitable. But the credit markets are likely to signal trouble, before stock markets, and they bare especially close watching.
The unknowns in China also loom large. In fact to a significant extent the Chinese economy is one big unknown. The Chinese government sets targets and then releases official data that inevitably shows it hitting its targets. But behind the facade of the official numbers, are big unkowns. It’s not that the Chinese central government is lying about the data. It’s worse. They don’t know what is really going on. The central government sets economic targets and local governments and businesses report good looking data that oftentimes has only a cursory relationship with reality. Much of the actual Chinese economy operates in the shadows. What is the actual amount of debt? How much debt is at risk of nonpayment? Does promised collateral actually exist? What are the levels of local government exposure to insolvent business ventures? How much debt is in dollar denominated loans and sensitive to currency movements?
In fact any question involving Chinese debt doesn’t have a good answer, except for the question of how well does the Chinese government understand its debt problem. We know that China’s central government appreciated that they had a real problem on their hands with a real estate bubble that was in many ways resembling real estate bubbles that sent other countries into deep recessions. We know this because they began to tighten credit and speak to the need to replace real estate and infrastructure investment with an economic model centered around consumer spending. We also know they underestimated the scope of the problem and overestimated their ability to unwind excessive real estate investments, because many signs point to the Chinese economy strongly decelerating and in response they reversed themselves on tightening credit and are now frantically easing.
Like the situation in the Eurozone with Greece, what we don’t know in China is whether these measures will be successful in postponing the day of reckoning. A lot of money has been borrowed and badly spent in China, and there will be repercussions. So far commodity markets have been signaling negatives for the global economy, recent Chinese data has been positively pointing to its economy gaining some traction in response to government easing, but the Chinese stock market has been selling off for the last two weeks, further spooking already nervous government officials. Once again, credit markets are worth paying particular attention to, in order to determine whether associated problems are growing and spreading.
Greece has been the focus of attention and been able to leverage bargaining power beyond its actual economic strength, largely because its European partners don’t know what the damage will be it if exits the Euro. The Chinese government is scrambling to ease credit, because it is behind the curve in understanding its negative economic exposure to bad debt. One thing we do know is that we’re at the point where fear has taken over from hope. The Euro is no longer bound by the hope of creating a vibrant economic growth zone. The Chinese government is no longer hopeful about being the master of its destiny, engineering a smooth transition to a new consumer economic model of sustainable growth. Instead, it is now all about avoiding disaster and finding a way to keep economies bumping along and not crashing.
That characterization would also apply to the United States, where the economy keeps bumping along just above stall speed. But it is also a known unknown that we don’t know the impact of the collapse of crude oil prices on an economy, where a significant amount of growth was concentrated around debt-financed expansion in the shale energy boom. As to any future market crash, credit markets should give an early warning if the unknowns turn out to be as bad as some fear. And what are those credit markets doing? As my colleague Joe Calhoun has opined, credit spreads are sending out pre-recession signals with spreads elevated over 100 basis points versus the lows seen last summer. So those unknowns are looking increasingly worrisome.