Clem Sunter

The Forked Lightning Scenario

2015-12-23 11:59

It is the season of cheer and goodwill, but it is also the time to be wary about the markets. Chantell Ilbury and I have been playing an outlier scenario for several years of a double dip in the stock market, in other words a repeat of 2008.

 We call the scenario “Forked Lightning” and at the moment attach a 15% probability to it. One of the global flags that increase its probability is a rise in interest rates causing major defaults worldwide in national debt, mortgage debt, corporate debt or consumer debt.

As I said in my recently published book Flagwatching: “The analogy I use to indicate the risk of an easy money policy is that you don’t know whether a patient in ICU will stage a full recovery until you have removed the drips. In the case of the world economy, the drip is zero interest rates. Let’s see what happens if and when the drip is halted. Perhaps you will find it was the wrong medication from the start.”

Janet Yellen, Chair of the US Fed, has started the removal of the drip by announcing a 0.25% increase in the US base rate. As she herself said, it is a cautious move and the Fed will monitor the response before it decides to implement a second increase.

These are soothing words for the investment community who still remember the 2008 financial crash and do not want any increase in the odds of a repetition.

Interestingly, the flag that was as good as any other in announcing the 2008 crash was a decline in US property values.  

Again I quote from the book: “In the last quarter of 2006, the Case-Shiller index- which measures property prices across the US- levelled out; and in January 2007 it began a fall which continued into the middle of the year. Accordingly, in mid-2007 we gave Hard Times a 50% probability, even as the stock market was continuing to rise, and made it neck-and-neck with Long Boom.”

In those days, Chantell and I were only considering an economic recession in contrast to the long boom that had been going on, and not a crash scenario. Since property is for many US consumers their major personal asset, our logic was that a decline in its value would trigger a pause in the growth of consumer spending.

Since consumer spending represents two-thirds of the American economy, this would usher in the greater economic austerity of a Hard Times scenario. We had never heard of sub-prime mortgages and were as much taken aback by the extremity of the loss in value of the markets as anyone else.

Nevertheless, once bitten, twice shy is the catchphrase.

Since 2008, the Case-Shiller index has recovered but not to the record level prior to the crash.

Moreover, the curve is now flattening out and US home sales in November, 2015 were disappointing. The US Fed increase in interest rates in this context could have unintended consequences in that it will raise mortgage rates.

On the other hand, the US economy has done better than any other advanced economy because of the youthfulness and resilience of the American population. The question is how much of the US recovery can be attributed to a record period of cheap money. Time will tell but the property flag must be watched closely.

The other red flag that comes out of our analysis is the size of sovereign debt relative to GDP. Japan has the highest ratio at 230% followed by Greece at 177%, and then Italy at 132%, Spain at 98%, France at 95%, the UK at 89% and Germany at 75%. The recommended maximum is 60% and South Africa is 46%. America, meanwhile, sits at 101%. The last time it was over 100% was during the Second World War.

Thanks to consistently high economic growth after the war, the ratio dived to a reasonable level for the remainder of the last century; but in the last 10 years it has soared again. The chances are that the US ratio still has further to ascend because of greater military expenditure in relation to the war on terror.

With the slowdown in China’s economy creating strong headwinds for the global economy, record low oil and commodity prices undermining the solvency of nations dependant on primary resources and the ageing demography of Europe and Japan, the risk profile of national debt is rising fast.

Perhaps it will be a South American nation that defaults first but the over-borrowed countries are generally becoming more vulnerable.

So Forked Lightning is a scenario which now must be borne in mind by any investor. We have not yet raised its probability from 15% but obviously we are watching the flags closely. It does reinforce the idea of having a diversified portfolio in equities, property and cash, maybe a third in each category.

The sensible objective is not to try and maximise the return on one’s wealth at this time by taking risky bets; but to protect what one has got and have some appreciation in value to offset inflation.


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