The dangers of being right for the wrong reasons: Part 2

In Part 2 of my thoughts on forecasts of financial crisis in 2016, I look at China and other potential factors which may shape the global economy this year.

China

For all Europe’s problems, I’m even more concerned that an economic crisis will occur in China. Again, it’s far from clear that this will happen in 2016 but it looks inevitable in the near future and it will have significant knock-on effects on the global economy.

Once again, private debt is the culprit. I don’t believe official figures (which actually show China to have a greater private debt problem than the one in America that led to the sub-prime crisis) to be anywhere close to being accurate and, with the large shadow banking sector and repackaged debt, the reality could be far, far worse.1 As long as the Chinese government instructs banks to keep lending whilst trying to manipulate the markets, rather than tackling the debt problem head-on, this is simply force-feeding Monty Python’s Mr. Creosote.

Other factors

To be fair to the Royal Scottish Cassandra, there’s nothing to say that crisis couldn’t break out this year. We all know what happens when tinder gets dry – eventually a spark tends to come along. If events in London (e.g. the Clarence Hatry case) could affect Wall Street in 1929, then it’s clear to see how even the smallest, seemingly unrelated factor could affect the global economy today. War, terrorism, currency fluctuations or sustained extreme prices in certain markets could all trigger a crisis.

For example, it’s impossible to ignore today’s incredibly low commodity prices – especially oil. This is not necessarily because of the depths they have reached but the longevity of these deflated prices. For example, the average WTI price over the last ten years is USD80.65 a barrel. This mark hasn’t been reached since 30th October 2014. In fact, since the daily barrel price went below USD60 in mid-December 2014, it has only spent 16 days (out of a possible 280) above that point – and for never more than three consecutive days. At the time of writing, the price was just above USD30.

That may seem like a good thing, with cheaper fuel prices meaning more money in our pockets and fewer distribution overheads for firms. However, it also means large-scale redundancies – by September last year, there were already almost 200,000 job cuts in the oil sector worldwide – and a potential undercutting of the shale gas (fracking) business, which is largely funded on high-yield (i.e. junk) bonds. If there’s a run on these to the point of illiquidity, that could have repercussions on the overall, already-depressed, commodities sector. However, that could in turn lead to the US Government deciding to back the frackers and 2016 could be the year of the ‘shail out’.

Right… but also wrong

All of these elements suggest that almost anything can happen – and that ultimately it seems inevitable that a major systemic financial crisis and sustained economic depression will occur – but not necessarily this year. The danger is, elements such as those extremely low commodities prices and political turmoil could act as a red herring; leading analysts to be right about a crisis but for the wrong reasons. This would lead to a market rally once initial panic had subsided, leading to even worse times as the real cause hadn’t been eradicated. If we understand that it hasn’t been, then we can also grasp that that it will most likely be a very bumpy path that we’ll travel on before the house falls down, Mr. Creosote explodes or the dry tinder bursts into the biggest forest fire capital markets ever seen (or I run out of metaphors).

We should be more concerned about our journey on that path right now and simply be prepared for our destination when we do get there. The path itself creates both opportunities and risks and these are not universally homogenous or symmetrical. I don’t know when we’ll actually get to the end of the path; nor for that matter does anyone else. In which case, we should be managing risk (which we can always control) and seeking returns (which we can do our best to influence) on that journey. To that extent this year is no different to any other, except that we are one year closer to that journey’s end than we were a year ago.

The major issue remains private debt levels and we will only see true, sustainable economic recovery if governments and central banks tackle that first. They don’t seem to have any notion to do so. The wallpaper will keep being applied, Mr. Creosote will keep being fed (by the Fed?) and the tinder will keep getting dryer. Be prepared rather than frightened.

Footnotes:

1 http://www.mbmg-investment .com/in-the-media/inthemedia/76