After the crunch
If things feel bad now, how much worse could they get? In line with our previous risk reports (Heading for the Rocks and Shooting the Rapids), we have identified three macroeconomic scenarios for the evolution of the crisis that began in the US sub-prime mortgage market and is now reverberating throughout the world economy.
Scenario 1: Our central forecast (60% probability)
Government stimulus stabilises the global financial system and restores economic growth in leading developed markets during 2010, albeit at lower levels than in recent years. This scenario underpins our regular analysis and is not the subject of this report.
Scenario 2: The main risk scenario (30% probability)
Stimulus fails, leading to continued asset price deflation and sustained contraction in the leading economies.a depression persisting for some years. The stubborn decline in global economic activity is punctuated by occasional rallies that are taken as signs of recovery, but these quickly fade as the underlying downward trend reasserts itself. The prominent role of governments in propping up banks and reviving domestic demand leads to strong political pressure for protectionism, effectively putting the process of globalisation into reverse.
Scenario 3: The alternative risk scenario (10% probability)
Failing confidence in the dollar leads to its collapse, and the search for alternative safe-havens proves fruitless. Economic upheaval sharply raises the risk of social unrest and violent protest. A Political Instability Index covering 165 countries, developed for this report, highlights the countries particularly vulnerable to political instability as a result of economic distress.
Although this document from the Economist is now several months old (from March 2009), it is helpful to reflect on the scenarios it presents.
- Scenario 1 with growth restored seems to be increasingly unlikely with perhaps a 20% probability. Freight traffic remains at very low levels and to date there is no driver on the horizon to change this fact. Protectionism is on the rise as the "Buy American" campaign shows. A repeat of the 1930s Smoot Hawley bill seems likely at this point.
- Scenario 2 seems to be the most likely course of events with a 60% probability. Rising protectionism and a decline in economic activity and exports seems to be the prominent trend. Deflation appears to be determined to correct the inflationary excesses of yesterday. This scenario would fit Robert Pretchart's view of a strengthening US dollar and plunging stock market.
- Scenario 3 has increased in probability in my view to 20%. At the present time there are strong pressures developing in Japan to reduce buying US Treasuries. If this occurs, or if the Japanese only agree to sell debt to the US denominated in Yen, a dollar collapse could quickly develop.
These are my estimates to date. Fast moving developments around the world could change these estimates quickly. While I expect a dollar upward bounce in the near term, it certainly is a counter trend expectation. Ultimately, with the course the US is on, the dollar will drop significantly as it eventually looses its reserve currency status.