After a bit of reflection and quiet contemplation yesterday on the what might be the greatest threat to financial markets in the coming decade, I came up with a list of about five potential threats. I did my best to synthesize everything that I have read or listened to in the past year. I also tried to imagine the unimaginable and to envision scenarios that are counter to current conventional thoughts regarding the future.
So here are the threats, in no particular order.
Failure to Institute Appropriate Reforms
A year after the failure of several major institutions and Congress has not implemented any meaningful type of reform. Capital requirements have not been increased. Instead of breaking up the too-big-to-fail institutions, the government is allowing—in effect, encouraging— them to grow. Credit default swaps still do not have a central clearinghouse and are still treated as securities rather than insurance. The shadow banking system remains unregulated. The government is continuing to prop up housing prices via tax credits and is continuing to give home loans to risky people for only a measly 5% down payment.
Based upon the prior examples alone, any future crisis has the potential to be much worse because of the failure to institute adequate and necessary reforms.
A Major Country Defaulting on its Debt
I’m not talking about Argentina or Turkey. I’m talking about a country like Japan (see this article), the United Kingdom, or the United States. Now, a credit downgrade might be more likely, but I think its well within the realm of possibility that any one of these countries could default within the next decade unless their governments address their budget deficits and spending habits.
According to the OECD, Japan’s debt to GDP ratio will likely rise to 197% next year. I bet that the United States will have a debt to GDP ratio of 100% next year. The United Kingdom will have a debt to GDP ratio of about 72% next year, the greatest its ever been in thirty years.
Inflation
Future inflation is the biggest thing about which everyone is worried, therefore this is probably the least likely to occur within this next decade. However with that said, inflation and the side-effect of rising interest rates has the potential to negatively affect a country’s debt situation. Increasing the costs for a country to service its already massive debts could very well induce a death-spiral that forces a country to default on its debt. Can you just imagine what it would be like for Japan or the United states if they were forced to pay double the rate for its long-term debt? I imagine it would not be very pleasant.
And as a reminder to those of us in the U.S., rates rose from the 50s to the 80s and rates declined from the 80s to 2010. Financial history is cyclical and there is nowhere to go but up for rates. Rates will eventually begin another 30-year journey upwards.
Conversely, since we are talking about just the next decade, a decade of world-wide deflation could probably be the most likely scenario simply because very few people consider it likely.
Global Catastrophe
Here are some catastrophic events that could serious consequences for global economies and markets:
- a 9/11-type terrorist attack somewhere in the world
- a global pandemic that kills millions of people
- a nuclear war: Israel/Iran; India/Pakistan; any other imaginable/unimaginable combination of countries
- a virus or bacteria or insect that destroys a large percentage of the world’s crops and food supply
As a sidenote, its not worthwhile to consider any scenario with a Mad Max-type result. When we’re in a wasteland fighting each other for fuel there is definitely not going to be any financial market to worry about.
“The Next Bubble”
“The Next Bubble,” whatever that might be, is probably another conventional threat to financial markets. Everyone knows they happen periodically and everyone knows that with all the money being printed by the government, this money has to go somewhere if people aren’t using it to pay down their debts.
Here are some potential future bubbles:
- Oil/Natural Gas – Hard to imagine, but it could happen again.
- Commodities – I’ve been reading how China has been stockpiling vast amounts of commodities to hedge against a depreciating U.S. dollar; perhaps this will be the next bubble?
- Debt – After so many investors were burned by equities and complex securities, investors have turned to “safer” government and corporate debt for their investment needs. If investor psychology has shifted towards a general preference for debt, this preference will eventually shift at the peak of demand as it always does.
- Real Estate – Another real estate bubble? I think its entirely possible. We’ll call it the Double Bubble. Prices are being propped up in the United States. Apparently there is a bubble in Canadian real estate (of all places). China is also a likely candidate.
- China – China in general is a place where people worry about a bubble forming.
- Alternative Energy – Solar, wind, geothermal, cold fusion (haha). Might become a bubble. I don’t know. But these alternative energy investments will surely suck if global demand for fossil fuels is near zero for the next decade.
Summary
In summary, I was able to envision five threats to the financial markets over the next decade: a major country defaulting on its debt, inflation (or an unexpected decade of deflation), global catastrophe, and “The Next Bubble.” I would be very interested to hear my readers’ thoughts and ideas on this subject. Its very hard to think about the future and possible black swan events, but definitely a worthwhile effort.
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