The Independent Market Observer

Problems Abroad: What to Worry About

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 7, 2014 12:36:00 PM

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Europe_2As we discussed yesterday, economic slowing in the rest of the world, while certainly a headwind for the U.S. economy, isn’t really something to worry about. U.S. economic data—3.5-percent growth last quarter, plus another month of more than 200,000 jobs created—seems to support that.

But unlike economics, where U.S. exposure is relatively small, our political and institutional exposure is intense. Here are some examples of problems abroad that should seriously worry us. 

European conflict escalates

The confrontation between the rich north, which is by and large doing okay, and the poorer south, which is not, is reaching the crisis point. Often caricatured as France versus Germany, the conflict is better expressed as the German central bank versus the European Central Bank. After Mario Draghi essentially promised that the ECB would step up its quantitative easing, the situation has escalated to a direct face-off between the ECB president and the head of the Bundesbank, with the very real potential for the euro to break up.

The demise of the euro would shake the world financial system, introducing uncertainty that could knock U.S. markets down substantially. While I believe the results, over time, would be positive economically, a surge of competitive nationalism in Europe would take us out of the postwar environment and back into a period more reminiscent of the 1930s.

Of course, this isn’t guaranteed (or even probable) at this point, but it’s concerning.

Tension in Asia continues to mount

A similar dynamic is playing out right now in Asia. Japan’s decision to substantially expand its quantitative easing program (and, not by accident, weaken its currency) will have a relatively minor effect here in the U.S. but a much larger impact in China. Think about it: two Asian nations, both of which depend on exports, and one unilaterally creates a significant competitive advantage for itself. China might well perceive this as an economically hostile act. Even if the Chinese don’t take it personally, they still have to respond.

China and Japan already have a complicated relationship. History, territorial disputes, and now economic conflict are all ratcheting back up. Many of these conflicts were less important in the good times. But with both countries now facing serious challenges, it becomes more difficult to compromise and much easier to blame the other. Both countries have records of aggressive nationalism and expansionism, and neither is likely to back down as confrontations accelerate and the stakes rise.

An uncertain future

The European Union was set up to avoid the kind of destructive, zero-sum competition that had driven the continent to centuries of war. And it’s worked; there's been nothing like the quasi-military confrontations between Japan and China. At the same time, we can look at the evolution of Asia and what's happening in Europe and recognize the similarities.

This is what I worry about. Economically, we may experience continued shocks, but the U.S. is well positioned to ride them out. Other areas of the world are in much worse shape overall—there, the doomsayers may well end up being right—and the consequences could affect us in a much more profound way.

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