Saturday, June 13, 2009

Ten Things That Could Still Go Wrong with the Economy

The recent buoyancy of the financial markets has created a sense of calm about the economy. The overall sense of panic has gone.
But there's still a wariness in the air, a feeling that the fragile "green shoots" of the recovery might be stomped out by some new crisis. People are waiting for the next shoe to drop.
Here we suggest 10 things that might stymie our recovery. Some are purely financial events. Others are geopolitical. And one involves these little piggies.
Did your favorite nightmare scenario make the cut?

1. Swine Flu Second Wave:
Typically, influenza outbreaks come in waves, getting worse with each one. The very ease with which we seem to have survived the first wave of swine flu may make us vulnerable to a horrific second wave.
2. Commercial Real Estate Collapse:
Various commercial real estate deals face trillions in refinancing obligations over the coming years. But the market is practically closed, ensuring massive bankruptcies and restructuring.
Why are lenders so freaked out? Because existing loans are going sour at a pace unlike anything we've seen in history. Because of that, even commercial real estate properties with strong cash flows are finding financing extremely difficult to come by.
3. The Option Adjustable Rate Mortgage Explosion:
Anyone referring to the "subprime crisis" has got to get with the program. The subprime wave of defaults is basically over. Now the question is, what about all the other types of mortgages? You know, Option ARM, Alt-As and of course, good old fashioned prime mortgage.
The big wave of Option ARM resets has yet to come, and given the drop in home prices, refinancing won't be realistic. Let's hope the homeowners can afford their new monthly payments.
4. Global Food Crisis:
As we saw last year, the global food supply teeters on the edge of adequacy. Any serious shock--floods in the Midwest, a war in Asia, social unrest in China, political upheaval in Thailand or Egypt--could result in shortages in countries that import large amounts of their food.
5. Israel Bombs Iran:
The Obama administration's openness to the Iranian regime may have the perverse effect of emboldening its nuclear ambitions. Very likely, the fears of the nuclear Iran are over-stated. It would probably behave like most members of the global nuke club, cowed by its own destructive power into behaving responsibly.
But Iran isn't the only country to worry about in the region. Israel may not be willing to tolerate a nuclear armed Iran, and may choose to strike out to destroy Iran's nascent nuclear capabilities. This would obvious raise tensions throughout the Middle East. At the very least, oil prices will likely spike and remain elevated following any military action against Iran. This, in turn, will slow the global economy.
6. A Wave of Municipal Defaults:
Historically, cities and states don't default on their loans very much. But as Warren Buffett pointed out, historical results don't mean jack because muni insurance wasn't around. Unless it gets a bailout, California may go bankrupt, causing the muni market to seize up, bringing public works and spending to a halt, kneecapping GDP.
At that point, with no ability to borrow, the other states will rush to default themselves, sparing their taxpayers any more pain.
7. Another Bank Run:
It seems unlikely, given the government's implicit guarantee of the banking sector, but it's always possible that investors or lenders could lose confidence in one of the banks again, prompting a financing run a la Bear Stearns.
If this happened, we'd be back to square one with all the confidence and bailouts since Lehman's collapse -- only, the government would have fewer bullets left in the gun.
8. Runaway Inflation: The Federal Reserve seems confident that it can "land the recovery." Is it right?
There's good reason to be skeptical that the Fed will be able to reduce the monetary base before it floods out into the economy, driving up prices and destroying savings. For one thing, the Fed has never really been very good at doing this. By the time the Fed realizes that inflation is taking off, it may be too late.
9. North Korean Missile Launch:
Wee dictator Kim Jong II has lulled the world to sleep, performing missile tests on a seemingly daily basis. What was once a cause for alarm now barely merits a bulletin on CNBC. In fact, the dollar has rallied on the nervousness.
But his neighbors in China, South Korea and Japan are freaked out and an actual war, or genuine provocation, could wreak havoc on far eastern trade. This might cause investors to flee towards the dollar, but it would be terrible for markets and economic activity.
10. Chinese Financial Crisis:
Most economic discussion of China these days is about how dependent the US government has become on China buying Treasury bonds. But China has lately learned that its own economy is dangerously leveraged on foreign demand for Chinese manufactured goods. The global downturn has helped expose the fragility of the Chinese economic miracle, and worse might be coming.
A collapse of profits in China could very well spark a banking crisis, much like the collapse of real estate prices did to US financial institutions. Very little attention has been paid to the fragility of the Chinese financial system, which is dominated by large, slow, non-transparent, often corrupt state-run banks and centralized decision making. Slowing exports could be the tide that goes out and reveals which Chinese banks have been swimming naked. And the Chinese financial system, which has almost no effective securitization and therefore high concentrations of financial risk, is much less prepared to deal bank failures than the US was.
Of course, this will be bad news for the US. Any financial crisis in China will hurt the demand for our debt, both public and private, driving up interest rates and slowing down the US economy. This, in turn, would reduce demand for Chinese exports, exposing shaky banks to risk of collapse all over again.

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