The Independent Market Observer

6/18/13 – An Updated Look at the Risks

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jun 18, 2013 9:15:00 AM

and tagged Debt Crisis, Market Updates, Europe

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Yesterday, we talked about the big picture and why the longer-term outlook for the U.S. is actually quite bright. I mentioned in passing that there are some shorter-term risks between here and there, and I wanted to spend some time today catching up on those.

The big one in the papers today is China. As you know, I’ve been very concerned about China for a long time. Most recently, I wrote about the decline in wage competitiveness and about some of the risks to the financial system, discussing in both posts the increasingly tense regional security environment in Asia.

Since then, the situation has continued to deteriorate. Chinese growth continues to slow, and the banking system is apparently under stress due to a cash squeeze driven at least in part by central bank policies. Interbank lending rates have spiked, and China now finds itself caught between demands for the central bank to inject more cash into the system and the current policy, which is aimed at reining in credit expansion. China has long managed its economy by injecting liquidity into the system as stimulus, but the decreasing marginal productivity of additional loans, combined with rising inflation, has forced it to start dialing that back. The country may now be in a position where it has to choose between two bad options—and there will be problems no matter the choice.

The regional security situation also continues to cook, the most recent development being an (unofficial) Chinese statement that Okinawa and the Ryukyu chain of islands may, in fact, belong to China, not Japan. Apart from serving as a major U.S. military base, Okinawa is a core part of Japan. China also continues to push its claims with other neighboring countries, such as the Philippines. Clearly, China is not backing off, and these problems are likely to get worse rather than better. Overall, the risks from China are greater than the last time we looked, and they don’t seem likely to decrease any time soon.

The other international risk is Europe. Although it’s dropped out of the headlines recently, the problem hasn’t gone away. Austerity is widely perceived as having failed; France is looking for more special treatment, not only in fiscal matters but also in trade; and unemployment in general (and youth unemployment in particular) is at unsustainable levels. Increasingly, Germany faces a choice between its own domestic political imperatives, which call for continued austerity but will probably break up the euro, and starting to spend, which may preserve the euro until Germany itself changes governments—German elections are due in September—and pulls out. While there doesn’t appear to be an immediate catalyst for problems, the balance between the creditor and debtor countries remains unstable, and it wouldn’t take much for Europe to make it back to the front pages.

Also coming up this fall is the next round of the federal debt ceiling debate in the U.S. Congress. Back in February, you may remember, Congress suspended the legal debt ceiling until May 1—and did not address it again. The Treasury department is now back in Defcon 1, to use the term I developed for the last two go-rounds, and is employing the “standard set of extraordinary measures,” to use the Treasury Secretary’s phrase from his notification letter to Congress. Didn’t know that, did you? We’re now running on borrowed time, and sometime this fall we will again hit the debt ceiling, with all of the political fireworks that entails. Judging from the recent IRS scandal, the parties are as unlikely to work well together next time as they have been before. To add to the fun, Congress also has to agree on a budget at that time.

As you can see, there are at least three significant risks out there, all of which may well end up causing something unpleasant in the next several months. To these, I would also add the Federal Reserve’s pending exit from the stimulus program, which will quite possibly start during the same time frame.

While the future is bright, we’ll have an exciting time getting there. Stay buckled in—turbulence ahead.

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