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The views from Mars

WorldWatch
1 October 2012

Markets remain preoccupied with possibility of a tail risk event…but perhaps they should not be; the great tail risk events are avoidable.

Martin Pluck

Is there an end in sight to the crisis that has gripped both real and financial economies for the last five years? Unfortunately, no. But the shape of the crisis is changing. The troubles of the eurozone have been stabilised, for now. The global banking system is much more resilient than it was. And economies that should be growing – in emerging Asia, eastern Europe, and Africa – are growing. But the fear focus has shifted as markets worry about the threat from elsewhere. 

If a Martian economist were to write a postcard home today it would probably read something like this.

‘Dear Friends, greetings from Earth. You may be surprised to hear things are not nearly as bad as expected. I find that plenty of economies on this planet are actually doing rather well. The big picture is a bit sub-trend, but nothing too scary. Those troublesome banks in the country they call America have been fixed. Europe has held together, to everyone’s surprise except mine. Companies are amazingly healthy. The developing world is getting richer – and no big wars! To be honest I can’t see why everyone is so depressed. Maybe it’s the weather, which is even worse than I was told. All the best – your old pal Mork.’

You can rely on extra-terrestrial beings to take the long view. Unfortunately, investment markets are pretty well the opposite right now. In a recent survey (by State Street) of 300 of the world’s biggest managers of money, over 70% said they expect a ‘tail risk event’ that will cause another financial meltdown within the next year. Global recession, euro break-up, and big bank insolvency were the most cited likely triggers for this Lehman-like scenario.

That’s odd – because while there are a couple of very wild cards in the outlook for the coming months, neither of them are on that list. And what is more, neither of them are very likely. Possible, but not likely.

For example, it is possible that the US economy will tip over the fiscal cliff – the roughly 4% of GDP that government is scheduled automatically to take out of the economy in personal tax hikes (i.e., expiry of cuts), plus payroll tax hikes, plus defence spending cuts, if there is no political deal to avoid the plunge. That’s enough to push the US into at least a year of recession from the second half of 2013. Last year US policymakers could have negotiated away this fiscal body blow, but in an atmosphere as poisonous as that of Mars, they did not. Why should the prospects of compromise be any better after November 6, with a bruising presidential election still fresh in the memory?

Forward P/E: Europe and EM Stocks Are Cheap

forward pe - europe and em stocks are cheap

Source: Factset, IBES, Morgan Stanley Research

The answer to that is the state of the US economy itself: everybody can see that it is in no shape to withstand a $600 billion hit. Housing may have stabilised, but that is a lone positive. Corporate investment – never strong – is turning down. Jobs are still not being created at scale. Households are still paying down debt. On balance indicators are getting slightly better, not worse, but that’s little comfort: at this point in the cycle the recovery should be strong, and it is anything but strong. The US is still primed for a second recession: good reason to stay well away from the cliff. And as Winston Churchill said “Americans can always be counted on to do the right thing…after they have exhausted all other possibilities.”

China Monetary Growth: Time for Stimulus

china monetary growth - time for stimulus

Source: Euromonitor, Morgan Stanley Research

Meanwhile China is just as much of a worry: with Chinese equities now down to around where they were back in 2000, it is fair to say that investors are not comfortable with the rate of the China slowdown, although there are signs of stabilisation. They are worried that the growth track is moving from cyclical slowdown to structural slowdown, as China exhausts the potential of investment-driven growth. Indeed, what growth there is, is in large part the fruit of continued over-investment.

China’s government still has the means to reflate the economy, if it chooses. But will it choose? The massive stimulus of 2009 left bad debts in the banking and shadow banking system. Local government has no way to pay for big new government spending. Politically the costs of too much stimulus, especially in terms of creating increased opportunities for corruption, are great. The Bo Xilai case is just the most extreme example of the problems the party now faces. With unemployment not a big problem and the demographics deteriorating, the authorities appear happy to allow growth to stabilize at their unstated 7%-plus target. So China’s economic and political fundamentals suggest a continued period of uncertainty and lower growth, and only a modest policy response.

China’s crisis is a long-term one; if there is reason to worry more than before, it is because Chinese politics are in ferment; there is a generational shift in power positions due to take shape before the year is out, and economic conditions are more testing than for many years. All this at a time when the health of the global economy is heavily dependent on elderly men in Beijing not losing the plot.

That adds up to several things to worry about. But when is there nothing to worry about? Policy actions have put a backstop to the eurozone crisis, and policy actions can manage the US and China as well. The great tail risk event is clearly avoidable.

And Martian economist Mork’s next postcard home may well just say ‘Wish you were here.’


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