Politics and economics: six worries for 2005

published 4 November 2005

The 19th-century novelist Marie von Ebner-Eschenback was first to point out in print that a stopped clock is right twice a day - and wittily added that "over the years it can thus boast a notable series of successes". In a Breakingviews article this week, the author and journalist Edward Chancellor introduces us to the Stopped Clock Club, a previously little-known brotherhood of professional investors and financial scribes. The Club, whose Chief Horologist' is The Spectator's Christopher Fildes, is a group of men (for "there are no lady members") who are chronically gloomy about the prospects for financial markets. They pride themselves on never losing money when the market turns down, but never seem to notice the profits they spurn by pulling out their money years too early. However, this year there appear to be so many potential nasties about in the global economy that these fundamentalists of pessimism may be about to find their time has come. Here are six things they worry about:

The complete collapse of the dollar

There is an overwhelming consensus among economists and commentators that, notwithstanding this week's sudden rally, the dollar will fall further in 2005. Over the last three years, the dollar has lost 30% of its value against the euro, experiencing a particularly sharp fall (4.4%) since Alan Greenspan's comments on 19 November focused attention on the record current-account deficit, which, thanks to America's love of spending and disdain for saving, is fast approaching 6% of GDP, or $600bn a year. Foreigners effectively lend America the difference, says Paul Blustein in The Washington Post, using the dollars they receive for the goods they sell to the US to invest in US assets, such as Treasury bonds. The net amount Americans owe foreign creditors has soared from $360bn to $3trn in just eight years. The problem is that the more this sort of indebtedness rises, the more reluctant foreigners may become to continue buying dollars. And the more reluctant they become, the more the dollar will fall.

The strange thing about this consensus view, however, is that most commentators expect the decline in the dollar to be orderly rather than sudden. Most find it hard to believe that the Asians, particularly the Japanese, big buyers of Treasuries, will suddenly sell out. Their own economies depend to a large degree on US consumer demand, says Heather Stewart in The Observer, so why would they want to exacerbate a further decline that would cut the competitiveness of their own exports? A precipitous decline in the dollar that hit the US economy hard (thanks to imported inflation and rising interest rates) could, for example, result in millions of Chinese manufacturing workers losing their jobs. Given the recent outbreaks of civil unrest there (see below), who would want that?

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But there could be a surprise here. As Bill Bonner points out on www.DailyReckoning.co.uk, if you see a train coming, don't you step out of the way? Similarly, if you see a currency that everyone agrees will fall, don't you sell it? Surely that means there is every chance the dollar decline will be less gentle and highly disruptive. The dollar could easily lose another 10%-20% against the euro, which would represent the "biggest financial shock the world has ever suffered". Americans may believe they can stiff their creditors - effectively "writing off" $3trn worth of foreign debt - simply by letting the dollar sink. They think a lower dollar will correct the trade deficit, and make US industries more profitable"From one situation that was too good to be true, they expect to go to another, also too good to be true." It isn't likely to be so easy. Instead, a rapid dollar decline could precipitate a financial crisis as jittery foreign investors pull out of stocks and bonds and end up throwing the world economy into recession. Bonner may be in a minority with this view (he is a happy member of the stopped-clock club), but he isn't alone. Warren Buffett has been concerned about the dollar for some years. He now holds $20bn of foreign currency contracts. As he tells Forbes magazine, $10trn of the US economy is owned by foreigners: "If lots of people try to leave the market, we'll have chaos because they won't get through the door," he told The New York Times. That could get nasty.

A message to investors who see Chinese expansion as a one-way bet: don't. According to Marc Faber, writing in The Daily Reckoning newsletter, 2005 is fast shaping up as the year of the unforeseen' hard landing in China's overheated and now fast-cooling economy. Certainly, the signs that "not all is well in the Middle Kingdom" are spreading. Consider car sales. They were doubling year-on-year in some months of 2003, have slowed considerably, and actually fell by 3.64% year-on-year in September 2004.

Profits of some car makers have already collapsed 30%, but "given the market-share-driven mentality of executives, production is unlikely to have been cut back, which means that inventories have risen sharply in recent months". Second, look at China's housing and commercial property markets. Both have cooled significantly: commercial space under construction is down more than 50% in the last 12 months.

The consensus view among investors, explains Faber, is that the slowdown in China is solely down to the government's cooling measures implemented a year ago. Once the economy has cooled down enough - so this happy theory goes - the restrictions will be lifted and growth will rebound. But the consensus is wrong. Why? Because China's "restrictive economic policies came at precisely the time the economy was about to cool down for cyclical reasons anyway", thanks to overinvestment from local entrepreneurs and spiralling foreign direct investment (FDI), both of which have led to overcapacity and bloated inventories.

What this means for 2005 is that capital investment, including FDI, will decline far more than is widely predicted, as huge production surpluses result in big losses for those - both local and foreign - who have invested recently. History in emerging markets and everywhere else suggests investment rushes end in crashes. "It would be most unusual if the recent great China investment boom ended any differently from the various canal or railroad booms of the 19th century, or the great European investment rush in Russia at the beginning of the 20th." That doesn't mean China won't have a future as a big economic and political power. It's just a warning that some form of "cyclical hard landing" will likely backfire on investors who see a continuous Chinese boom - and the momentum it provides to global growth, and especially US growth - as a sure thing.

As if this weren't enough for China enthusiasts to worry about, a second danger is bubbling to the surface: the widening gulf between rural poor and urban rich that makes China one of the world's most unequal and divided societies is threatening to explode in a wave of political uprisings and civil disorder. Joseph Kahn in The New York Times reports from Wanzhou, a Yangtze River port city, on how a street scuffle between an elderly downtrodden porter and a man claiming to be a public official - the official' threatened to pay to have the worker killed - flared up within hours into a serious riot involving up to 70,000 people marching on the district government building and setting it alight.

It is an extraordinary tale of a minor street quarrel ending in an all-consuming riot, as word spread through Wanzhou of the injustice done to the poor pole man' by the overmighty official. But as a spontaneous outpouring of protest against authoritarian rule, it is far from unique in today's China. In November, as many as 100,000 farmers in Sichuan, "frustrated by months of fruitless appeals against a dam project that claimed their land, took matters into their own hands", stopping work on the dam for days, and seizing government offices. It took 10,000 paramilitary troops to quell the unrest. And in mid-December, up to 50,000 migrant workers rioted in Guangdong after police beat to death a teenager they found stealing a bicycle. Police statistics record that the number of public protests reached nearly 60,000 in 2003, an eightfold increase over a decade. In short, despite its economic expansion - or because of it - "China is having more trouble maintaining social order than at any time since the Tiananmen Square democracy movement in 1989". That doesn't make it the safest place to invest right now.

At MoneyWeek, we have written endlessly about the coming crash in the UK housing market, so we won't go on about it too much. Suffice it to say that we still think 2004 was the year that the market finally cracked - mortgage approvals are at a nine-year low - and are pretty certain that things can only get worse. The likelihood is that the picture will get bleaker. According to Nationwide, the average house currently costs 5.8 times the average income. The long-term average is closer to four. To close the gap, prices would have to fall 31%. The consensus is that prices will fall gently if at all, but as far as we're concerned, the odds are the great UK housing crash has already started. Note that transactions are back to 1995 levels. No one is buying and when there is no demand for something, its price falls - be it a house or a second-hand car. This will soon have a profound effect on consumer spending and could end up pushing the economy into recession.

The general consensus is that most commodity prices have peaked. The last year has been exceptional, in that the increase in demand for oil almost matched overall economic growth, thanks to surging demand in China, said David Buchan in the FT. But that pressure should now ease. The only thing that would send prices back above $50 a barrel this year would be a Middle East crisis such as a US strike on Iran's nuclear facilities, or a revolution in Saudi Arabia ousting the superwealthy princes who rule it. But the fact is that oil doesn't have to go much higher to have a nasty effect on global growth. Having run up by more than 50% last year to a peak above $55 a barrel, it's currently hovering in the $40-$45 range. That's not as bad as it was, but it is still a third higher that the 2003 average of $29. Even if oil prices end 2005 pretty much where they are now, that's still enough to put the brakes on world growth. And it looks like a plausible scenario. In the short term, the direction of the market will be driven by factors difficult to gauge - such as weather and sabotage in the Gulf - but in the long term, how can oil go anywhere but up? Even if China crashes, its demand for oil will stay high - the cars and air conditioners will keep running - and demand in the rest of Asia, particularly in India, is growing fast, as it is all over the Middle East. The days of easy oil really are long gone: in a decade, $40 a barrel could well look cheap.

While all eyes were on the oil price in 2004, the prices of base metals were quietly reaching 15-to-16-year highs. But after three straight years of rising metal prices - a year longer than the usual cyclical upturn - the question now is whether the bonanza will continue, or whether the market is on the verge of a downturn. According to US commodities guru Jim Rogers, they'll just keep going up: "the real money is yet to be made", he told Fortune. China will certainly wobble in coming years, but its long march to economic dominance will continue regardless, and that will dramatically boost demand for commodities across the globe - for many years. Yet while demand rises, supply is tight. Only one lead mine has opened in the last 25 years, says Rogers, and no one is investing in tin or in nickel. And it isn't just hard commodities the contrarians think might rise. One of the ten possible surprises suggested by Morgan Stanley's Byron Wien is that, following a terrific harvest in 2004, which drove some agricultural commodities to "distressed levels", 2005 will see growing demand for food globally and a lousy harvest. Prices could then rise sharply and companies such as Bunge, which has large inventories, benefit substantially.

In America there are solid grounds for worrying about inflation, says Anatole Kaletsky in The Times. So far, inflation has been "quiescent, but not perhaps as innocuous as the markets suppose". The consensus view at the start of last year was that US inflation would ease from 2.3% in 2003 to 1.8% in 2004. Instead, it has averaged 2.6% in the year as a whole and reached 3.6% in the 12 months to November. Many commentators are putting that down to a blip due to the soaring oil price, but there is more to it than that, says Edward Hadas on www.Breakingviews.com. With the dollar falling, imports (and commodities in particular) are getting more expensive, and that creates inflationary pressure, something that, with unemployment low and import substitution expensive, the economy will find hard to resist. In the UK, inflation is also becoming more of a risk. The old measure of inflation (the RPIX), for example, tells us that prices are rising at well over 3%.

In the US, said Nell Henderson in The Washington Post, minutes published this week show that the Federal Reserve is more than concerned about the dangers of higher inflation - and what it calls the "potentially excessive risk-taking in financial markets" - which its "prolonged period of policy accommodation" has encouraged. That means that rates are sure to rise, and probably more than most analysts (who see rates moving from 2.25% to between 3% and 5% by the end of the year) think. That, in turn, would have a significant impact on global growth. Ten-year government bonds have already increased from 3.5% in June 2003 to 4.2% today, says Edward Hadas. To tempt investors, they should be a lot higher: 6% by the end of the year is a "distinct possibility". Higher rates would hit consumption in the US, and that in turn would hit growth all over the world - just as China looks like it is (at best) slowing too.

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