The Independent Market Observer

What Can Go Wrong

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 13, 2012 8:49:19 AM

and tagged Debt Crisis, Market Updates, Europe

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A couple of days ago, at the end of a post on reasons for optimism regarding the economy, I promised that the following day we would discuss what could go wrong. And of course, something did go wrong—I didn’t discuss it. In any event, Friday the 13th just seemed like the right time to discuss the downside—so here we are.

Uncertainty continues

Uncertainty is one of the more nebulous factors impacting the economy, but it’s also one of the more powerful. One of the most significant factors holding back any recovery is that both consumers and businesses are uncertain about the future. The natural reactions to uncertainty are to save more and postpone spending decisions. We see this in the business world, with record-high levels of cash on corporate balance sheets. Uncertainty is also probably delaying hiring decisions.

Should this level of uncertainty continue—say, because of continued federal gridlock after the election or continued financial turmoil in Europe—decisions will continue to be postponed and the weakness may feed on itself. In some respects, to paraphrase Woody Allen, the economy is like a shark—if it isn’t moving forward, it dies. Uncertainty-induced stasis will not be good for anyone.

Financial system freeze-up

There are a couple of ways the financial systems could freeze up. The first is through a collapse of the European banking system. Right now, the Spanish banking system is being rescued because of the possible contagion effects. The Irish and Greek systems are already in rescue mode. The Cypriot banking system is entering that mode and others are potentially in line. While the rescue mechanisms hold, this should not be a problem; but both the supply of and demand for rescue capital are being stretched—and both are subject to further shocks as well. This could lead to a Lehman moment, when banks become unwilling to lend to one another, suspecting that the counterparty might not be there the next day.

An unforeseen failure by one or more of the major banks could also induce a financial system paralysis. This could be something like the J.P. Morgan CIO trade losses, the HSBC anti-money laundering failures, or—this is my personal bet—litigation against banks arising from the LIBOR price-fixing scandal. The estimate of $22 billion in liability from the scandal reported in today’s Financial Times does not include any litigation from customers or from others affected by the price fixing—which could be enormous—or any fines for cartel actions—which are currently being investigated by both the U.S. and the EU. Either of these could add billions to that total. At a time when banks are already weakened and under attack, this will not help at all.

Governmental errors

The poster child for the potential impact of governmental errors is last year’s U.S. debt ceiling debacle; it could play out this year in a rerun on the debt ceiling or on the pending U.S. fiscal cliff—or both. With most political commentators calling for no resolution of the fiscal cliff problems until after the election and with the debt ceiling again getting closer every day, the possibility of a government-induced financial crisis is still very much alive. If nothing is done, the effects of either of these will be enough to result in a recession, at the very least, making this an oncoming train that must be dodged.

The U.S. is not the only possible venue for governmental errors. Europe is in the middle of a very delicate renegotiation on how it is structured, which includes internal debates in each of the European states. China is trying to navigate a slowdown, as the government attempts to stimulate the economy enough—but not too much—to engineer a soft landing. Governments around the world have to get many things right and do so consistently.

These three things—uncertainty, financial system gridlock, and governmental errors—are the biggest of the known unknowns, in the Rumsfeldian sense, and we should always remember that it is the bus you don’t see—the unknown unknown—that runs you over.

Keep a sharp watch!

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