JUNE 20, 2011
There is a well known saying, purported to be derived from an old Chinese proverb: "May you live in interesting times". It's more of a curse than a proverb, really. Regardless of its origins, it is most certainly true of the world today. These are interesting times.
It's interesting that during times of prosperity and economic stability, current trends are extrapolated into the indefinite future. The future is assumed to be bigger, better, and just as stable as the present. It's no wonder, then, that prices of all sorts of assets, particularly stocks and real estate, tend to experience dislocations from measures of underlying value during such periods of prosperity. When the future is assumed to be brighter, people are willing to pay more.....more for stocks, stretching the price/earnings ratio.....and more for houses, causing a dislocation from underlying fundamentals such as rents, per capita GDP, incomes, and inflation. People are also far more willing to take on credit when they believe that prospects for the economy are rosy and that their salary will increase sufficiently to allow them to pay off the debt and save enough so that they will not have to eat purina in their old age.
But when risk returns to the radar and things get a little dicey, assets experience a compression in the spread between their prices and the measures of fundamental value. In his fantastic book, The Black Swan, Nassim Taleb explains that major, unpredictable events are both underappreciated by the general public in terms of their role in shaping finance, the economy, and consumer psychology, and disproportionate in the impact they have. And while black swan events are inherently unpredictable and typically occur very quickly, it's nevertheless interesting to ponder some developments that are taking shape in the world around us. They may not be black swans, but they are certainly a shade of gray...
Gray Swan #1: A Greek default
It's a certainty that Greek will in fact be forced to embrace some form of debt restructuring, so this one is hardly unexpected. The bigger question is how the financial system in Europe will react if bondholders (many of them are big banks) are forced to take major losses on their bonds, which are nothing but IOUs from Greece....and it's all but assured that those won't be honoured in their entirety.
This has not been lost on many European banks. In fact, those in the UK have radically reduced the amount of lending they are doing with Eurozone banks, fearing another 'Lehman' event like in 2008 when US investment bank Lehman Brothers went belly up, marking the start of the great financial crisis. A must-read article by The Telegraph highlights the mounting credit market tensions:
Senior sources have revealed that leading banks, including Barclays and Standard Chartered, have radically reduced the amount of unsecured lending they are prepared to make available to eurozone banks, raising the prospect of a new credit crunch for the European banking system.
Moves by stronger banks to cut back their lending to weaker banks is reminiscent of the build-up to the financial crisis in 2008, when the refusal of banks to lend to one another led to a seizing-up of the markets that eventually led to the collapse of several major banks and taxpayer bail-outs of many more.
While the funding position of UK banks is far stronger now than it was back in 2008, the banking systems of several other major European countries, including Spain, Germany and Italy, are showing increasing signs of weakness.
Analysts at UBS have warned that eurozone banks are “particularly exposed” having not done enough since the crisis to cut their reliance on the wholesale funding markets and remain acutely sensitive to the withdrawal of liquidity from the inter-bank market.
There is nothing but increased tensions coming for European credit markets. And should some of the larger banks fail in the aftermath of a Greek default, those nasty little derivative credit default swaps (the things that Warren Buffet called 'weapons of financial mass destruction) kick in, crippling any counterparty, which may turn out to be US banks. If Greece goes, you can bet that Ireland and Spain are next in line....with Spain being widely regarded as too big to save. It's one more reason that I am a big fan of companies with no debt or very little debt. There is more than an insignificant chance of another credit market event in the next few years, and my bet would be that it will be connected to eurozone debt issues that spill over to North American credit markets. So what are the implications for Canada? Here's what Finance Minister, Jim Flahery had to say, courtesy of the Globe and Mail:
“There is a real danger of contagion stemming from the situation in Europe”
While the direct exposure that Canadian banks and insurers have to Greece is relatively minor, Mr. Flaherty said the situation has the ability to impact the financial system globally if it's not dealt with. That being said, he added he expects it will be resolved.
Let's hope. While not related to black swans, in the same speech given by Flaherty, he stated that he is quite happy with recent cooling seen in the housing market and will take no further actions to cool it. We'll see.
The very real possibility of more financial market tensions over eurozone debt is not the only gray swan on the radar. These things tend to flock.
Gray Swan #2: A hard landing in China
A point I have made repeatedly is that I believe that China's centrally-planned and heavily manipulated economy will experience a major slowdown. Remeber that even if it slowed from its ultra high flying 10% annual clip to 'only' 5% (still a higher rate of growth than most of the Western world), it would have major repercussions for the global economy. You may recall that TD recently had the following to say on the topic:
...The Canadian economy would be quite vulnerable (to a hard landing in China). Given Canada’s modest exports to China, the direct impact on trade would be limited. However, there would be enormous indirect effects. First, a dramatic slowing in China’s economy would be a blow to the world economy. Indeed, a global recession would be a material risk. Second, China has had an enormous impact in raising commodity prices in recent years. A hard landing in China would spark a substantial commodity correction. The risk scenario presented is one where China’s economic growth falls to 5% in 2012 and then edges back up to 7% in 2013.
Under this scenario, world economic growth would be almost cut in half to 2% and commodity prices could fall by 30-40%. This would shave 1.0 to 1.5 percentage points from Canadian economic growth. It would also impact commodity-rich provincial economies the most. The analysis shows that Canada’s economic fortunes are deeply tied to developments in China.
Yeah...that would suck. Yet China continues to demonstrate a shocking propensity to undertake ridiculous infrastructure projects (like building empty cities) for the sake of keeping their young men working and their economy (seemingly) booming. On the topic of those empty cities, which we've discussed at length in the past, you have to see these incredible satellite pictures. This is only one minor issue facing the emerging superpower.
An absolutely incredible Wall Street Journal editorial outlines what may be the most pressing issue facing the Chinese economy:
The first wave of problem loans originating from the 2009 economic stimulus is about to hit the banking system. If the reports citing anonymous officials are true, Beijing is considering assuming responsibility for some 2-3 trillion yuan ($300-450 billion) of these loans that were made to local government borrowing vehicles.
The scale of such a rescue is staggering--at about 7% of GDP it is bigger than the U.S. TARP program. It also comes out of the blue; the banks' audited accounts still show that their nonperforming loans have fallen dramatically. Yet the bailout would nearly equal the total amount of bad loans spun off from the four major state banks during their restructuring in the early 2000s.
How did this happen? When the global financial crisis impacted China's exports in 2008, Beijing ordered its banks to support a massive credit expansion to create jobs and stimulate growth. The banks eagerly went into action and in 2009 and 2010 made new loans amounting to a total of 20 trillion yuan ($3.1 trillion). Of these a significant amount went to local government borrowers. Estimates of how many of these loans would go bad range from 25% to 30%, which suggests a total figure of 8-9 trillion yuan.
...China's national debt narrowly defined is 20% of GDP, but if all obligations of the sovereign were added up it is closer to 80%. This is before this round of local government loan acquisition and before considering the other 70% of the stimulus loans made to state enterprises, which history has repeatedly shown are bad credits.
With few voices able to question its actions, it seems that Beijing will continue along the path of increasing systemic financial leverage. The weight of its inability to halt profligate spending by local governments and state enterprises will be put squarely on the backs of future generations.
...The experience of these two years shows that a large part of the Chinese economic miracle has been built on a foundation of ill-considered lending and accounting sleight-of-hand.
So with these marauding waterfowl on the horizon, how have Canadians responded? Why, to take on more debt, of course! From Stats Canada:
The ratio of household credit market debt to personal disposable income advanced to 147.3% in the first quarter, as growth in household credit market debt (+1.3%) outpaced that of the personal disposable income (+0.7%). The debt-service ratio also edged up in the first quarter, continuing a trend that started in the third quarter of 2010.
Yup, risk is a forgotten four letter word. We have such an incredible tendency to assume that our temporal reality is a long-lasting and stable norm. We certainly do live in interesting times. We have major, unsustainable trends at play in Canada, and the inevitable normalization of these trends will mean major adjustments to the economy and the Canadian way of life. Not doomer stuff....but come on....can debt accumulation really keep looking like this?
And if the trends are in fact unsustainable, what does that imply for consumer consumption, the lion's share of economic growth in Canada and representing 10% more in terms of its contribution to economic growth today than in twnety years ago (and don't give me that Keynsian garbage that creditors will pick up the slack when debtor consumption falters)?
We live in interesting times. And just to drive the point home, let me end with this David Madani video interview with Rob Carrick in which they discuss the direction of house prices in Canada (thanks to VREAA for transcribing the interview):
Rob Carrick: “You’re predicting a 25% decline over 3 years, is that the worst case scenario?“
David Madani, Economist, Capital Economics: “No, it’s basically a baseline view .. the fact that prices have risen so much relative to income… we can’t see how income growth alone will close this very large gap between price and income…”
Carrick: “Where do rising interest rates fit into that?”
Madani: “Actually our outlook right now for the next few years is one of interest rates remaining where they are…“
Carrick: “So if interest rates were to rise, that could make things substantially worse”
Carrick: “The Canadian market is often distorted by what’s going on in Vancouver… I mean, that market is just unstoppable…”
Madani: “25% is an average… this is not just a Vancouver story, we see this bubble-phenomenon across Canada.. … we don’t think it’ll get as bad as in the US, but we do think a ‘substantial decline’ is in store for Canada .”
At least some people get it...