Yesterday, I posted an update on the rising risks in Europe. After I wrote that piece, I spent some time thinking about other risk areas that have fallen off the radar screen a bit and decided that today would be a good time to address those as well.
China remains a big underappreciated risk area. The foremost risk right now is the evolving confrontation—and I use that word advisedly—between China and Japan. The dispute over the Senkaku/Daioyu islands continues, with a gradual ratcheting up of the stakes. Last week, Chinese ships actually locked targeting radars on Japanese naval ships, an action that typically precedes an attack. This is a serious escalation of threats and falls one step short of an actual attack. It made the front page of the Wall Street Journal today, as well as other specialized political and military news sources I follow. I first mentioned this dispute several months ago, but it continues to get worse. A war in Chinese waters could potentially draw in the U.S. as a Japanese ally, with unforeseeable consequences.
Why would the Chinese government be willing to push this so hard? One reason might be that they anticipate a need for an external enemy to distract the population from domestic issues. China does seem to have negotiated a soft economic landing at the end of last year, but more issues keep coming to light, including the op-ed piece I linked to from a senior Chinese banker about risks from wealth management products. More and more stories are highlighting the financial fragility of the system, and environmental issues are getting greater play as well. None of this is to say that things will get bad immediately, just that the risks continue to rise and the margin for error continues to get smaller. Should shooting start, or China have a hard landing, one of the major growth areas of the world could disappear quickly.
No discussion of risk would be complete, of course, without a stop in Washington, D.C. The fiscal cliff deal was cheered in the markets, largely because it averted a massive tax increase. But, on spending issues, it just punted for a couple of months. We are now more than a month into that grace period, and—to no one’s surprise—the spending cuts have not even begun to be negotiated. On the front page of today’s New York Times, the president is quoted urging Congress to put off the spending cuts.
They may. The problem, though, is that having made most of the Bush tax cuts permanent, the government now must deal in some way with spending, or admit that it cannot solve the deficit problem. The Congressional Budget Office sees total debt hitting 77 percent of GDP by 2020 unless the government acts, and that includes the spending cuts in the sequester. If the sequester is postponed or eliminated, the problem will be even worse.
One more point, which warrants further discussion tomorrow, is that the 77-percent figure, while justifiable, is in fact just plain wrong—as in, too low. This is a risk that no one is talking about but should be.
Overall, these are three of the most prominent risks that have not gone away. The market reaction to Europe on Monday just suggests that, if and when these or other risks become more visible, we might see a reaction there as well. Volatility has been noticeably absent in the past couple of months, and it might not be smart to bet on that continuing.