My concern was that a perfect storm of a commodity crisis, a credit crisis, and a currency crisis were hitting us at the same time. I was worried all that could overwhelm the financial system. With respect to the commodity crisis, there is now some reason for hope. In the case of oil, the world is no longer in denial that it is a over-supply problem, not an under-demand problem. The suppliers or producers of oil are beginning to talk, which is a needed first step. Each also recognizes that truth is merely another political tool and don’t pretend to believe each other,which is a honest first step. They are almost at the capitulation stage. Another leg down, and they’ll be there! After maintaining an incredibly tight 97% correlation between oil prices and the stock market during January, that linkage appears to be fraying . . . good!
This commodity crisis is also largely responsible for the credit crisis. The high-yield bond market in the U.S. financed most “frackers,” and it is estimated that 25% of those producers will take bankruptcy. However, that is already factored into the market. Junk bonds have already tanked without any major destabilization of our credit markets. U.S. banks also hold a great deal of loans to oil companies, but with $700 billion of “excess capital,” our banks would survive if every single dollar of their oil loans was written off. (As bad as it may be, the Dodd-Frank Act gives me comfort at a point like this.) Don’t worry about the U.S. banks!
But, oil is not the only contributor to bad loans. How about the developing world, such as China? Wells Fargo just published an interesting study on this and found only 5% of the world’s banking assets are exposed to the developing markets. (Naturally, developed markets borrow far more than developing markets.) The two developed nations most exposed to the developing nations are Austria and (shockingly) Greece, both of which are quite small.
Another component of the credit crisis are the “zombie” banks of China, which have enormous bad loans on their books. (This reflects the central government causing a gross miss-allocation of resources, which is covered up by bad bank loans.) Is there any realistic possibility of the large Chinese banks failing and dragging down the rest of the world? Theoretically yes — but not as a practical matter. China would torpedo the rest of the world to keep a billion people from rioting in the street. If necessary, they will simply “print” enough yuan to bail out their banks. Of course, this would cause the value of their currency to tank mightily — not good, but far better than crashing the banking system.
The third crisis haunting us is a possible currency crisis, possibly precipitated by a massive yuan devaluation, albeit unlikely. Even without China doing something stupid, there is already currency-friction between the dollar and other currencies, as the Fed’s tightening posture is inconsistent with the ECB and Bank of Japan. The Fed will have to soften their position or risk setting off a currency war. They will soften their position.
None of this means we will not have a recession, however. There is no case of our country experiencing a second financial crisis without first experiencing a recession during the interim, and we have not had a recession since the 2008/9 financial crisis. The bear attack that the stock market has suffered so far this year is more likely a predictor of another recession than another financial crisis, which is fine. (The economic data does not suggest another recession, even if the stock market does.) Recessions come and go. They are good for capitalistic economies in the long run. But, I’m not nearly as worried about another financial crisis as I was a month ago.