Not One, But Many Sources of Risk...
Greg Ip:
The many things that prey on our minds: A big hairball of risk: Perhaps the most disconcerting aspect of the world’s current flight to safety is the lack of a single overriding threat to justify it. China is slowing, but hardly in recession. Europe is in crisis – but when has it not been in the last three years? And America – well, there’s that fiscal cliff later this year but it’s hard to find any investor thinking that far ahead…. What I think preys on the minds of financial and business-world risk takers is not a single threat but a multitude of them, regurgitated in one big hairball of risk. And all are about policy.
1. The easiest to understand is China…. The downsides of China's tiáo kòng (”macro control”) are well known: state-directed allocation of credit and investment is wasteful and distortionary. But the upside is that when the taps are opened, the effect is almost immediate…. Investors have learned to put enormous faith in tiáo kòng: as quickly as the authorities put the brakes on, they can release them. “Weak data to prompt effective support,” is how Barclays headlined a typical report Friday…. China’s record of managing growth is not to be taken lightly but the policy that guarantees 8% growth with no booms or busts has yet to be invented. If China suffers a hard landing this year, it will only prove its leaders are human. Odds of a good outcome: 80%.
- The most insoluble is Europe. It has faithfully followed Robert Feldman’s CRIC cycle: crisis, response, improvement, complacency…. The optimists are convinced that Germany will bend if that’s the price of saving the euro. What they may not appreciate is that there is no single “Germany” to nod his head when some line is crossed; the country is a mosaic of competing power bases who may not coalesce around a solution in time to save the region. Odds of a good outcome: 60%.
3. The most perplexing is America. The fiscal cliff at the end of the year is a problem in itself, and symptom of a larger problem…. Odds of a good outcome: 70%.
The key takeaway is that while a good outcome is the likeliest scenario for each, the combined probability of all three turning out well is only one-third. And by the way, that’s without throwing in all sorts of other risks…. Is it any wonder that the marginal investor or business would prefer to hold Treasury bonds or sit on cash? And that sort of disengagement can make economic pessimism self-fulfilling.
Well, yes, it is a wonder. If you are investing for the long term, 7% earnings yields on U.S. equities are a powerful inducement to buy and hold, and wait out the crisis...
