“There isn’t anybody who knows what is going to happen in the next 12 months. We’ve never been here before. Things are out of control. I have never seen a situation like it.“
This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period. None of us have ever seen a situation like today’s. Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues. They are a varying mix of all of these. And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.
This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’. We cannot know what will happen next. But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them. The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.
RISING INTEREST RATES COULD SPARK A DEBT CRISIS
Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years. And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more. The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:
“You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2”
• And the Fed was not alone, as the chart shows. Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt”
• There also seems little chance that this debt can ever be repaid. The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month
China is, of course, most at risk – as it was responsible for more than half of the lending bubble. This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.
China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008. Similar risks face the main developed countries as they finally have to end their stimulus programmes:
• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
• $8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested
There is only one strategy to manage this risk, and that is to avoid debt. Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.
THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE
After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.
Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):
• In H1, disposable income for urban residents averaged just $5389/capita
• In the rural half of the country, disposable income averaged just $1930
• The difference between income and expenditure was based on the lending bubble
As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.
Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk. The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector. As Xi said once again in his opening address to last week’s National Congress:
“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.”
China will therefore no longer be powering global growth, as it has done since 2008. Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.
This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact. For example, Company A may have no business with China and feel it is secure. But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.
PROTECTIONISM IS ON THE RISE AROUND THE WORLD
Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.
These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.
China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001. At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.
But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low. What will happen if the global economy now moves into recession?
The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:
“There are many great English cheese (sic), so you don’t need to buy French.”
No family tries to grow all its own food, or to manufacture all the other items that it needs. And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas. But Populism ignores these obvious truths.
• President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
• He has also said he will probably pull out of the Paris Climate Change Agreement
• Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:
“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.
At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.
Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.
POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart. The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own. This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes. As the chart from ipsos mori confirms:
• Most people in the major economies feel their country is going in the wrong direction
• Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
• Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
• 59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy
This suggests there is major potential for social unrest and political chaos if the elites don’t change direction. Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.
You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:
“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”
We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans. Time spent on these today could well be the best investment you will make. As always, please do contact me at firstname.lastname@example.org if I can help in any way.