Is this the most famous cup of coffee in movie history?
The quivering mug
In probably the greatest publicity fluke in modern cinema, Columbia Pictures released The China Syndrome twelve days before a near-catastrophic meltdown at Three Mile Island nuclear plant. It was an accident which ended America's flirtation with nuclear energy and sent them scuttling back towards a dependence on middle-eastern oil which was, to say the least, consequential.
But I digress.
In one of the great spine-tingling moments of '70s cinema Jack Lemmon's character, a manager at the plant, sits alone in the control room and through his coffee cup senses 'a vibration' from the nuclear core. This sets him on the path to discovering that terrifying negligence and dumb complacency by politicians and construction companies has left the plant vulnerable to a massive meltdown of the reactor. The film foreshadowed not only Three-Mile Island but a truly terrifying nuclear disaster at Chernobyl just a few years later. Which brings me, in my role as Cassandra-in-Chief, to this month's theme:
Have we just felt the financial equivalent of a 'vibration'?
In my Investment Outlook over the last couple of months (free with every blog, folks, don't you skip it) I've been warning of an on-coming correction in the stock market. It duly arrived mid-January. The odds were that it would be modest, as it has (so far) proved, with the FTSE 100 drooping around 10% from its peak. For now, technical indicators suggest that the immediate danger may have passed. But the question prudent speculators and intelligent pension investors need to ask is whether it was in fact an early tremor, warning of a more violent dislocation to come.
In March 2007, six months before the first really big quakes from the US subprime crisis hit, the market had what was dismissed by most pundits as a 'wiggle'.
Please click to enlarge
Overnight, China had made a sudden move to clamp down on runaway share speculation, provoking a big drop in the Shanghai stock market. Here, markets which had been sailing higher in blissfully calm waters instantly plunged 8%. Western investors had no particular cause to fret over that Chinese move. It was the panicky reaction itself which provided a hint that vertigo was setting in, that large investors were prepared to bail out rapidly and that, beneath the surface, greater anxieties lurked.
WHEN CHINA SNEEZES
Fast forward two years and here's a taste of the kind of headline which accompanied the start of this sharp decline:
- 'China credit tightening drags down Wall St'
- 'Why China may be overheating'
- 'Commodities slide on China fears'
Investors, having piled into China and the Asian economies in the belief that they've largely escaped the dead hand of the western debt crisis, have just begun to wake up to an appalling possibility: that China has been busy setting up a monumental debt crisis of its own.
One of the pre-eminent Wall St hedge fund managers, Jim Chanos, who made his name and fortune predicting and betting on Enron's destruction, has recently attracted a lot of publicity (not to mention ire from China's cheerleaders) by making a bold and controversial call.
He believes that Chinese residential property, along with all manner of other commercial building, is in a bubble of stupendous proportions which is sure to burst. Watch the urbane and interesting Mr Chanos explain his thinking in this video clip (to skip the preamble start around two minutes in):
Chanos isn't just flapping his mouth - he's betting big on a collapse in those industries in the region he sees as most at risk, including housing, construction, building materials etc.
If this were a parochial eastern concern, we out West might be justified in giving it not a moment's thought. Unfortunately, China is the main - make that the only - alternative to the crippled US and European economies as an engine of world growth. While developed nations have languished in recession, we've looked to Asia and the commodity-rich nations to haul us out.
Indeed since the crisis began China, fuelled by a gargantuan stimulus package from Beijing's central planners, has been sucking up imports from every mine, refinery and pit across the globe, providing millions of jobs at home and abroad in its insatiable hunger for more building and new infrastructure.
But now, as Chinese property prices bubble up and a potentially major outbreak of inflation looms, the government is beginning to withdraw that easy credit. Suddenly, China's role as chief growth driver (and therefore ours as piggyback rider) is coming into question. So if Jim Chanos is right - and among uber analysts he is not alone - we could witness a massive crash in Chinese housing and construction in 2010.
Some of the ghastly ramifications of this are what Donald Rumsfeld would describe as 'unknown unknowns'. But among the 'known knowns' would be: a crash in world raw materials stocks, a collapse of global commodity prices, huge damage inflicted on businesses dependent on exports to China and the prospect of another major leg down in the world economy.
But the eastern behemoth, although the biggest, is far from being the only danger to our putative recovery. Monsters lurk far closer to home. And last week, some of them started to bare their... well, their snouts.
PIGS FLY! (as the price of bacon plummets)
Portugal, Ireland (Iceland / Italy), Greece and Spain - or, as some smart-aleck analyst has monickered them, the 'PIGS' - are currently swilling around in a cesspit of debt from which escape can only be a messy business.
We've already seen the Irish housing industry flushed down the toilet and with it much of its banking sector. But now there's a whole array of basket-case nations around Europe caked in government debt, lining up for a trip round the U-bend. Here's a quick run down of the star names:
The 100-pound gorilla in the room. A minnow among European economies but its heavy-spending government is having to borrow 13% of its GDP this year to pay its bills which, with their tax receipts in the tank and an economy in the sewer means it is, theoretically at least, at risk of defaulting on its debt. Such an event would drop numerous European lenders (especially German banks) who own those bonds deep in the Scheiße. And if Greece defaults and cannot pay its debts, it cannot insure the customer deposits at its own banks. They might then get their own 'Northern Rock'-type panic except, this time, not just at one or two institutions but at every bank. They are currently locked in negotiations with the nervous Germans and the EU to find a solution - and most commentators believe the Germans can't afford not bail them out, which is why the default risk is theoretical - but any bailout could have the other PIGS lining up to get their snouts in too...
So that'll be the four-hundred pound gorilla, then. Spain, as we cheap-flight junkies know, saw a tremendous building boom up until 2008, especially on the Costas. It soon became absurdly dependent on housing and construction - an incredible 60% of all domestic loans in 2007/8 were related to the real estate sector. Banks were badly hit when many of these investments went belly up in the crash and, just like here, the government came rushing to their aid. This has (so far) prevented a banking meltdown but Zapatero's bank bailout has put taxpayers on the hook and, with unemployment approaching 20% (yes, you read that right) investors are beginning to question Spain's ability to bridge its own debt-gap in 2010.
RIGHT, SO WHO'S THE 800-POUND GORILLA?
Yes! It's our adored ex-Iron Chancellor, the man who, lest we forget, in 2008 single-handedly saved the world economy. Wouldn't it be delicious if, just eighteen months later, he had to go cap in hand to the IMF for a bailout?
Friends, that is the prospect many serious analysts are now contemplating if we don't get our government spending under control, and fast.
It's hardly surprising we're in trouble (given that Dr. Brown's prescription for solving an epic debt crisis has been to borrow a whole shed-load more), because a recent study by Kenneth Rogoff, former head of the IMF, shows that throughout history government debt crises almost always follow banking crises - precisely because governments are so keen to ride to the rescue. The record shows that, usually, disaster strikes for these countries about two years after their banks go bust.
RING OF FIRE
After Japan, our debt burden (debt as a proportion of what we produce) is the biggest in the whole wide world.
Unfortunately the government debt figures above are already out of date -
- The major central banks are now all talking about how they will withdraw monetary stimulus measures. These have been a major reason why interest rates have stayed so low, and when rates rise...
- The carry trade becomes difficult if not impossible to maintain, because as rates rise your borrowing costs rise, your profits disappear and the value of the dollar itself goes up and therefore...
- Traders who borrowed in dollars to execute carry-trades have to dump their highly-leveraged positions as the buck rises, otherwise they get wiped out. They sell the foreign assets and currencies they hold, forcing down the value of those currencies and assets and inflating the value of the dollar, creating more pressures to sell and leading to a vicious cycle. Exactly this scenario was responsible for much of the damage in the crash of 2008.
If the worldwide dollar carry-trade unwinds again as the greenback surges, US stocks bought in that trade will fall and a big share and currency sell-off can be expected, especially in emerging markets like Brazil and Hong Kong but also in the UK, Australia and the Eurozone, including those poor little PIGS.
THE CHINA SYNDROME
Put all these factors together and what you have is a dangerous cocktail of risks, opening up the renewed possibility of what markets fear most: contagion - that nuclear-like chain reaction of events which led us from a bunch of failed subprime mortgages all the way through to full-scale global economic meltdown.
To sum them up:
- Withdrawal of monetary stimulus leads to interest rate rises - or increased fear of interest rate rises;
- An inability to pay their debts or borrow in bond markets leads PIGS to the very edge of default, leads banks to take another huge loan hit and the UK to the door of the IMF
- The US dollar surges and the carry trade unwinds, leading to a plunge in any asset prices and currencies bought in that trade
- The Chinese government tightens stimulus taps for fear of inflation, triggering a collapse in Chinese property values, a halt in construction and a global commodity crash
While the occurence this year of a straight flush of all the above would seem a trifle...unlucky... the fact that all these are being seriously talked about, not by nutters in blogs but by major players, sends us a stark message.
This time, contrary to all appearances, the risks to your money are not falling as the market soars - they are rising.
Fortunately, market movement almost always 'tells'; it invariably whispers a technical warning to those with an ear to hear, some time before any calamity strikes. The crashes of 1929, 1987, 2001 and 2008 could all have been avoided. As a chart-nerd, watching out for those tells is my job.
Yours, if you want to protect your investments, is to avoid complacency. These risks may not materialize for some time, or indeed they may never materialize (I'm not a seer, just an investor who likes to know his risks). So we stay in the game and continue to ride the tiger - until it starts getting hungry. Whatever you do though, don't be spun a line. To the uninitiated, Gordon Brown may appear to have saved our economy in 2008, but look more closely...