The year ahead is going to be a tumultuous one, challenging in political, economic, and financial terms. Despite this, there are opportunities for those prepared to take advantage of them, because uncertain times mean that market share is up for grabs. And no, it’s not a coincidence that there are 12 trends for 2012. I discarded a bunch more, but it’s such a catchy title I couldn’t resist.

I’m going to approach these 12 trends with three objectives: What is important? Why is it important? And what does it mean to you?

And I’m going to start with the bad news, and end with the silver linings.

1)    Declining American influence – America’s absolute and relative influence in geopolitics, economics, finance, and the military is declining for a host of reasons: the rise of competing powers like China, India, Brazil, and others; the very expensive military adventures in Iraq and Afghanistan, which have sapped America’s willingness to engage in aggressive political and/or military action; the Arab Spring, which eliminated Middle Eastern strongmen like Mubarak who followed America’s political lead, and the continued stalemate over the fate of the Palestinians, means that America’s influence over this critical and unstable region is at or near an all-time low; the Great Recession, which has sapped America’s economic and financial clout; and the dysfunctional stand-off between Republicans and Democrats that has frequently led to policy paralysis.

The implications of this are a less stable, more dangerous world. America may have gone back and forth on whether it wanted to be the world’s policeman, even though it truly was the global cop, and it’s inability to fill that role now means that the world is a more dangerous place.

This sets the stage for sticky situations to emerge, such as the twin nuclear threats from a suddenly even less-stable North Korea, and the only slightly more stable and geopolitically ambitious theocracy in Iran. It also leaves more elbow room for the ever-ambitious China to expand its power and influence, notably in south Asia and the South China Sea. It also leaves critical global issues, like what to do about climate change, without essential leadership.

The implications of this is a world where there are more likely to be more, and more serious, geopolitical, financial, and economic crises, and greater uncertainty in virtually every aspect of life. Others may not always have agreed with American policies, but they will miss America’s steadying influence as it ebbs from their lives.

2)    Ho-hum! Just another financial crisis (European edition) – The daily drumbeat of scary headlines dealing with the financial crises in Europe have gradually deadened everyone’s awareness for how dangerous the situation truly is. In particular, Angela Merkel is juggling hand-grenades, and hoping that she won’t drop any, and that none of them will go off unexpectedly. Germany is the only European country with the potential to stop the rolling crises that are affecting Europe, and then only if Merkel acts in a timely basis. To do this, she must let Greece go bankrupt instead of propping it up, shore up the banks, notably German banks, that have bought far too many dodgy EU bonds in the past, allow the European Central Bank (ECB) to become a lender of last resort, with the ability to stop a run on European bonds, and halt the bond market attacks on other European countries, starting with Portugal and Ireland, but extending to the much bigger countries like Spain, Italy, and even France. But Germany doesn’t want to do these things, and German voters are adamant that they won’t subsidize what they see as the lazy, profligate lifestyles of southern Europeans. But if Germany doesn’t act, and in a timely fashion, it may lose the ability to act at all, and come under attack from the bond markets as well. Indeed, German bonds are no longer being bought with as much enthusiasm as they were even two months ago. If Germany doesn’t act soon, it may lose the ability to do so at all.

Remember what happened in the American financial markets in 2008? If Germany doesn’t act in time, we could see the same kind of thing happen in 2012, this time starting with a run on European government bonds. From there a run could spread to those banks – American as well as European – that hold too many of these bonds. And once such a run started, the most dangerous question of all would emerge: “Who’s next?” Investors, frightened by the panic, would look to sell any and every questionable credit, and their attention might turn to the various U.S. state and local governments, like Illinois, California, and Harrisburg, Pennsylvania, among many others, that are struggling with their finances.

The U.S. Federal Reserve has become the de facto lender of last resort to the entire developed world, and would undoubtedly step in and support the banks and markets with everything they had. But this time, remembering the callous, greedy ingratitude of last rescue of the banking industry, American voters and the American Congress would likely tell the banks to drop dead. It was a hard enough last time to get Congress to bail out the banks; this time I suspect it would be impossible, even though failing banks would take the global economy down with them. Moreover, the Fed doesn’t have anywhere near as many bullets today as they did in 2008, and Fed Chairman Bernanke already has some Republicans, notably Ron Paul, baying for his blood over the quantitative easing from the last crisis.

The danger here is frighteningly real, and even greater than the risks we faced in the panic of 2008. Yet, the steady drip of crisis headlines and last-minute rescues has left many people convinced that nothing will happen. If it does, it will catch people flat-footed, not because they didn’t know there was a crisis, but because they have been hearing about it for over two years now, and have tuned it out. We could muddle through, and probably will – but the risks are far higher than most people realize. It will be important to have thought out a Plan B to deal with the unthinkable, if it happens, one that prepares you and your finances for a bigger repeat of the 2008 panic. Again, it probably won’t happen – but it’s better to have a plan and not need it, than need a plan and not have it.

3)    Yes, China’s influence will continue to rise, but…  Napoleon famously said, “China is a sleeping giant. Let it sleep.” Well, China’s very much awake now, and throwing her weight around – although cautiously. If I were (God forbid) Emperor of China, I would require my minions to tread cautiously, to smile a lot at our trading partners and neighbors, and to make our gains slowly, one salami slice at a time, never appearing too greedy or overreaching. I would practice soft diplomacy, offering aid and comfort where I could do so cheaply, loudly proclaiming our respect for other countries’ internal policies, taking leadership positions in things, like climate change, where I knew I was going to have to make changes anyway, and generally trying to look like a good global citizen. I would act, in short, as if time were on my side, and I was going to be the next Big Thing.

And generally speaking, that is precisely what China is doing – except that every once in a while the mask slips, and the avarice and aggression shows, as with the boundary disputes with other countries, especially as related to the South “China” Sea, which China (the nation) seems to be trying to interpret literally as being a Chinese lake.

But China has an Achilles’ heel – several of them, in fact – and does not have (much) time on its side. Its biggest weakness is that it is aging faster than any other significant country on Earth. Because of its One Child policy, China’s population is expected to peak, and begin declining, sometime around 2020 – within the next 10 years. And its labor force is already in decline, even as the demands for higher wages push its cost structures higher.

Meanwhile, although there is a great deal of pride in China’s new affluence among the Chinese, that affluence is not evenly spread, and there is unrest among those who remain poor. Add to this the widespread corruption of Chinese officials at all levels, which often provokes revolts, like the one in Wukan, which leads to simmering dissatisfaction among many Chinese.

This will further be exacerbated by the fact that China’s factories are automating almost as quickly as those of the developed world, which threatens to slow the rate of job creation, productivity, and affluence markedly over the next 10 years. Yet, China dare not automate; to do so would mean a loss of competitiveness, which would produce even worse results as industries would move elsewhere.
So, with that in mind, what would I, as self-appointed Emperor of China, do? Worry about a future I couldn’t control, and for which I could not see a clear path forward. The next 10 years will mark the beginning of the end of China’s ascension, and if I were Emperor, I’d think about retiring to some warm, cushy haven before the revolution came. Chinese Spring, anyone?

The implications are for China to step up its attempts to increase power and influence, and throw its weight around even more actively before that power starts to wane, but as quietly as possible. Look for China to try to make this the China Decade, especially in finance, trade, and geopolitics, as it attempts to pull in as much as it can while it can.

4)    American Spring? Meanwhile, closer to home, while those on the political right like to dismiss the Occupy movement (e.g., Occupy Wall Street), the fact that the movement happened at all is the most significant part of it. Indeed, Time magazine made protestors its “Person of the Year”, and that’s not restricted to just the Arab countries. The Occupy movement and protests against cut-backs in many developed countries had many of the earmarks of the Arab Spring: protestors saying that their governments serve an elite clique and not the people; lots of people, especially young men, who cannot find work despite months or years of trying; and a belief that the political system is neither representative nor responsive. Just because winter has fallen, and the Occupy settlements have been disbanded does not mean that the dissatisfaction has gone away. And with increasingly dysfunctional government in America, the potential is there for a much stronger protest movement against the System, however that is defined. American Spring, perhaps? It sounds unlikely, but not as unlikely now as it did before, and it won’t be restricted to America for discontent will grow in all developed countries.

This is especially true as the boomers move towards retirement, only to find that their either don’t have the resources to retire and that no one is going to donate them, or that the civil servant pensions that they were promised are unaffordable.

The protest movements have only just begun, and they are going to be acrimonious, disruptive, and at times hijack the political process.

5)    Mixed signals for both weaker – and stronger – economic growth.  Europe and its prospects are dragging the global economy down. The uncertainty in Europe, combined with the painful budget cuts in Greece, Ireland, Portugal, Italy, Spain, and the United Kingdom, mean that Europe is now in recession and a drag on the global economy.

Meanwhile, China, which had been concerned about inflation, and hence was hiking interest rates in a bid to slow it, has now reversed itself, which I can only interpret as concern that growth will slow more than they want. That’s a potential positive, as it will add stimulus to the global economy.

Canada, which has to date seemed to skate above most of the problems of the rest of the developed world, now seems to be experiencing slower growth, with an unexpected jump in the unemployment rate, while its housing market is looking pricey, frothy, dangerous, and much like America’s prior to the collapse in 2008, especially in condo development in its major cities like Toronto, Vancouver, and Calgary. Moreover, its consumer debt levels are exceeding the levels of American consumers in 2007, and no less a figure than Mark Carney, the highly respected Governor of the Bank of Canada, has warned consumers and banks alike to cut back on consumer borrowing. Canada could be arriving late for the financial meltdown of 2008 – but if its consumers don’t mend their ways, they will get there.

And yet, America, which until 2008 was seen as the world’s engine of growth, seems to be picking up for no specific reason. Actually, this was almost inevitable because of the natural dynamism and entrepreneurship of the American economy. What has prevented America from rebounding earlier, or more strongly, has been the housing market, which is still in horrendous shape – but slowly improving.

So how will this balance out through 2012? Assuming that Europe doesn’t crash and burn, and drag everyone else down with it, and that Iran doesn’t precipitate a significant war in the Middle East, then America will continue to recover, its jobless rate will continue to decline (slowly), the world will lick its (economic) wounds, and things will slowly get better.

Accordingly, while I continue to counsel my clients to have a Plan B in their back pocket if things do go bad, my primary advice is the prepare now for better times ahead. There are problems – big problems – ahead, and the American election in 2012 is not going to help, but for 2012 we are likely to see an improving environment, and opportunities re-emerging for those with the courage to grasp them, as I outline in Trend #7 below.

6)    Climate change accelerates – and the consequences will multiply. The most significant and portentous climate news of 2011 was the discovery of methane gas bubbling up in the Arctic Ocean off the north coasts of both Siberia and Alaska. Methane is a far more potent greenhouse gas than carbon dioxide, and the melting of the Arctic ice cap, combined with the rise in the temperature of the Arctic Ocean, has started to release methane from the ocean floor. As well, as temperatures rise in the northern polar regions of Siberia, Alaska, and Canada, the permafrost melts, releasing even more methane into the atmosphere. The amounts of methane that could be released by both sea floor methyl hydrates and permafrost are staggeringly huge, and could dramatically accelerate the rate of climate change. If this trend continues, not only will the debate over climate change be over, but humanity will be forced to race to keep up with the potential changes.

As it happens, the vast majority of climate scientists – something approaching 95% – now agree that climate change is happening, and that humanity is at the very least a significant contributor to it. Since I speak to lots of different kinds of audiences, I can tell you that most groups now accept that climate change is happening, even those that have been among the most vocal doubters. The doubts they now raise are more along the lines of whether humanity is to blame. But from my point of view, it no longer matters: if your house is on fire, you don’t throw gasoline on the fire, regardless of how it started. That’s roughly the position we’re in now.

In 2012, we will get more information about the release of methane, and can only pray for good news. Meanwhile, brace yourself for more strange, and increasingly extreme weather. And because climate is a chaotic system (where chaos theory is a branch of mathematics), it is literally unpredictable. This means we can’t tell whether we will get floods or drought, hurricanes or tornados, or something else unforeseen. But it won’t be business as usual, either.

7)    Innovation as Steve Jobs’ legacy.  Jobs didn’t invent innovation, but he sure popularized it! Innovation has become a corporate religion in recent years, and with good reason: innovation can allow you to disrupt the marketplace, scoop up market share, increase profits, and win friends and influence people, just as Jobs and Apple have done. Yet, innovation is hard, especially because there’s a natural resistance to change and to the real risk-taking that innovation requires.

But if there is a theme for the corporate world in 2012, it is that now is the time to get serious about innovation. As an innovation specialist who runs seminars and workshops for corporate clients, I’m seeing this on a daily basis in genetic and medical research, agriculture, the automotive industry, the insurance industry and finance generally, plus just about every other sector of the economy. And technology itself embodies innovation. Indeed, the idea of a technological company not working hard at innovation seems like recipe for extinction. The world is changing rapidly, and there are lots of new opportunities – and disasters – out there. It’s raining soup, but if you just stand there, looking up in surprise, you’ll drown!

8)    Who dares, wins. Such is the motto of Britain’s fabled SAS – one of the world’s premier commando groups. But their motto applies equally to unsettled times. During such times, it’s easy and very, very tempting to hunker down, conserving cash, and wait for lazy, easy times to return. But study after study shows that companies that continue to market aggressively, and pursue research into new ideas, new products, and better results for their customers make far more inroads with modest expenditures during bad times than spending far more during good times, when everyone else is competing hard. Moreover, loyalty is won when times are bad, both among consumers, and among employees. And best of all, you can often accomplish a great deal with careful planning and foresight rather than lavish expenditures. This is where strategic planning comes to the fore. The time to be thoughtfully aggressive is when your competitors are playing turtle.

9)    The Red Invaders. The emergence of a Chinese middle class not only means upward pressure on food and fuel prices, it also means a vast invasion of Chinese tourists bearing money. For those countries and regions able to attract such tourists, it means a new source of revenue, and a big shot in the arm. And, as with all ethnic groups, it also means serving them the way they want to be served in terms of language, food, and customs. To the winner go the mega-spoils.

10) Haggling returns to North American retailing. Smart retailers are recognizing that it’s no longer enough to post a sign saying “10% off” to attract consumers, but that consumers are more demanding now, and are moving away from the traditional “no haggle” approach to buying. Moreover, haggling offers two additional benefits to consumers: it’s become somewhat of a game where they can enjoy the thrill of the hunt; and it offers bragging rights when talking with their friends. As a result, haggling has been emerging in two different ways, one passive, and the other active.

The passive form of haggling is to wait for sales. You can witness this almost anywhere when consumers see an item they like in a store, and ask if it’s on sale. When they’re told that it’s not, they turn up their noses, and say they’ll wait until it is. This might be described as “temporal haggling”, where the consumer is saying, “I’ll wait until you lower the price before I buy it. And if you don’t lower it enough, I won’t buy it.” Smart stores are responding in creative ways. Some salespeople say, “No, that’s not on sale, but it will be starting next week,” which amounts to a counter-offer. A smart consumer will reply by saying, “Can you put it aside for me until then?”, implicitly offering to buy it if they do. Some salespeople say no, others say “Sure.” The net result is that store and consumer have haggled over the price to agree on a sale/purchase. Yet the smart retailer actually has an advantage in this exchange: they get to name the sale price in temporal haggling.

By comparison, in active, more traditional haggling the consumer takes the initiative, saying something like “What’s your best price on this widget?” If the salesperson replies with the sticker price, the haggle is over and the consumer leaves. If the salesperson names a price, the consumer responds dismissively, and says, “I wouldn’t pay a nickel over $X for that”, and the salesperson can choose to respond or not. This is, as I say, traditional marketplace haggling.

If a retailer wants to capitalize on the re-emergence of haggling into the North American marketplace, they need to anticipate it, and come up with a range of responses. One might be to say, “We can’t discount this item today, but it is going on sale next week. Would you like to put a deposit on it to hold it until then?” The retailer regains the initiative this way, and moves towards a close. Or better still, the retailer should look for a way to add value rather than cut price by making a counter-offer like, “No, I’m sorry, we can’t discount that item. But we can offer you a 50% discount on a matching accessory if you buy it.”

Regardless of approach, though, retailers should be prepared to return to marketplace haggling, and have a range of responses ready to deal with it. Consumers, as always, should decide what they want, and what their bottom line is in getting it.

11) Health care magic blossoms. Putting aside the issue of cost, which concerns everyone, the ability of health care to solve problems is beginning to move at computer speeds, in part because IT is increasingly being used by doctors, nurses, hospitals – and patients – to manage health care, and in part because research is increasingly being done using smart, powerful computer tools to perform research and execute treatments. Among the changes in the immediate future of health care are:

• The rapidly rising ability to repair failing hearts and minds (or at least brains) and other organs with stem cells. Stem cell treatments are starting to move out of the laboratory and into the operating room, and 2012 will see hundreds of people receiving this kind of therapy.
• Similarly, 3D printers, which have been in development for roughly 20 years, are now good enough that they are starting to be used to create replacement organs from a patient’s own tissue. This will gradually move into mainstream medicine, with replacement hearts, livers, and kidneys being at the top of the list.
• Quadriplegics will increasingly be able to interact with the world through prosthetics controlled by thought alone, either through electrodes that interpret brain wave patterns, or implanted chips which interpret specific thought-impulses.
• Retinal implants are starting to emerge that can help blind people discern light, shapes, and some objects. The implication is that we may be able to help aging boomers improve their failing eyesight as they age – one of the biggest complaints of old age!
• Health care is increasingly falling into the hands of the patient – literally. Smartphones, which are fundamentally wearable computers with all the capabilities of what used to be called “supercomputers”, can now work with Bluetooth-enabled sensors to monitor various aspects of health, from the vigor of your workout, to the health of your heart, to the level of your blood sugar. This will lead to a revolution in health management, with consumers sometimes way out in front of practitioner.
• Likewise, as patients become more and more comfortable with researching medical conditions and treatments online; they are demanding an increasing role in their own diagnosis and treatment; becoming active, important advocates for fund-raising and acceptance of treatments; and blunt critics of health care practitioners through social media and word of mouth. Smart practitioners are accepting this trend and rolling with it. Old school practitioners are resisting, but may wind up steamrolled by it.
• Crowdsourcing of tough diagnoses, and novel solutions to the medical and financial problems of health care promise to open yet another front in the health care revolution. This follows on with the success of crowdsourcing in helping leading-edge research scientists in astronomy (galaxyzoo.org) and protein research (Foldit game softwear).
• Sequencing your genome gets cheap. Sequencing the first genome cost billions of dollars and took decades to perform (culminating in the Human Genome Project). Today it costs about $1,000 (although analysis costs significantly more). Within 10 years, it will cost $100, and analysis will cost about $500 more, and will provide you a complete run-down of where your vulnerabilities lie, and what you can do to forestall future health problems. For 2012, we will see incremental advances towards that goal, with major diseases identified, and a short list of things you do – and don’t – want to do or eat prescribed. This is the true beginning of personalized medicine, and it will revolutionize health care.

12) Technology accelerates in 2012. It’s hard to know what to leave out: electronic mind-reading? Glasses that emit sounds and smells to allow you to enhance social media? The proliferating tablets and smartphones with ever-more wondrous abilities? Here’s a partial list of things I think demonstrate trends that will become increasingly important:

• 3D printers – As well as making replacement organs, 3D printers are coming into the price range of consumers, and may mean that you can buy your own desktop factory. Need a replacement screw for a door? Make it yourself. Need to duplicate a key? Ditto. See a nifty device on TV? Download the plans and make it yourself. Of course, who knows what the ink cartridges will cost.
• Near-eye monitors – These look like glasses, but are computer monitors. They’re the lineal descendents of jet fighter heads-up displays, and will revolutionize the way we use computers, particularly smartphones, but have been hampered by high costs. Prices are starting to approach luxury consumer levels, so applications will start to appear in things like immersive gaming, personal entertainment theaters, medical imaging, and augmented reality.
• Augmented reality through your smartphone – Augmented reality is overlaying information on top of the view from your Mark 1 eyeball, much as Google Street View overlays the names of shops on a photo. You’ll be able to hold up your smartphone’s camera and have your phone overlay directions, stores, infrastructure views, or whatever else might be useful to you. This gets better when you can view the results in your near-eye monitors.
• Cloud computing explodes – Owning a computer is so 2010. Cloud computing is rapidly placing the resources of today’s supercomputers in your hands for pennies a minute. One researcher used one of the commercial clouds to try to break his password to a social media website by brute force, just to see if he could do it. Using the cloud and standard code-breaking techniques he did it in minutes, and it cost him 39¢. As the tools to harness this power get more powerful and easier to use, the potential of the cloud will be adapted by more and more users.
• Siri & copycats + babbling to your smartphone – Siri is an application of the iPhone 4S that allows you to speak to your iPhone and get it to do things for you. This might be setting a count-down timer, converting milliliters to fluid ounces, finding an address and directions from your present location, or looking up a phone number (all of which I’ve done). Apple is offering this technology as a beta version now, but every Siri request goes through Apple’s servers. This means the potential exists to assess what people want to do, and come up with solutions, improving the results really quickly, making personal avatars (also called PDAs, butlers, or assistants) much more valuable in short order. And that means everyone will rush into the field. This will lead to lots of really bad copycat applications, but ultimately a revolution in how we use technology.
• Biometric passwords – Our world is becoming so full of passwords that need to be foolproof (meaning our tendency to forget them) that biometric passwords are almost inevitable, and they are beginning to appear. They will be expensive at first, but gradually retina, fingerprint, voiceprint, and other means of making sure you are you will become cheap and commonplace, and then you will become your own password, no memory required.
• Robots – Everyday robots are here, but they are clunky, expensive, or just plain cute. That’s changing very quickly, and 2012 will see more and more of them appearing in more and more places. Typically these will be commercial settings, but health care is one place where robots make sense and will be used. Rosie the Robot won’t be washing your dishes this year, but she’s coming – if you’re willing to pony up the equivalent of the price of a luxury car.

The stock markets have fallen out of bed since President Obama signed the ludicrous debt ceiling deal. I don’t wonder about that; what I wonder is why they took so long. I was expecting stocks to fall two weeks earlier than they did. But now the question becomes: What happens next? This is actually a much deeper question than it seems, because it goes far beyond just the behavior of stock prices and markets. But let’s start with stocks.

When I started work on this blog, the S&P 500 index was at 1,119 which put it almost exactly half way between the October 4th, 2008 high of 1,565 and the March 6th, 2009 low of 667. Specifically, it was 452 points below the high, and 446 above the low, so almost exactly half way. (And if you want to look at that in percentage change terms, it’s 40.4% down from the high and 39.9% up from the low.) That would seem to imply that while there may be more risks yet in holding stocks, we may be getting through the worst, and should start compiling lists of stocks we want to buy. Indeed, since I went to virtually all cash in my personal and corporate investment accounts more than two weeks ago, I am waiting for buying opportunities, and creating just such lists.

But there’s an old stock market cliché for times like this: Never try to catch a falling knife. Don’t buy when markets are in free fall, because you’ll only wish you waited longer. Barton Biggs, a well-respected market analyst and money manager, was interviewed on Bloomberg TV, and said he had a list of great stocks that were now bargains, but that he wished he’d waited longer to buy them – and that was 150 points higher. So, that being said, what are the risks, and how will we know when the worst is over?

Well, first of all, you need to consult a properly licensed investment advisor for specific information, someone who knows your financial position, tax status, age, risk tolerance, cash flow, and all the other pieces of information that go into making a proper assessment of your investment needs. I am not that person, and this is not intended as investment advice. Here endeth the small print.

Risk management

Let’s take a step back and see if we can find some benchmarks. To do so, I want to go back to a concept that I’ve written about repeatedly in this blog, and use regularly with my consulting clients: the ratio of risk managment. What are the possible risks? And what are the potential returns? Once you’re assessed those, you’re in a better position to make decisions, rather than just guessing whether the markets will go up or down.

By my definition, risk is the cost of being wrong. So, if we invest in stocks now, or don’t invest in stocks now, what are the risks either way? Let’s start with the potential positive risks, because, unfortunately, this is a much shorter list.

Could the markets surprise us on the upside? There are three factors that drive stock prices: interest rates, corporate earnings, and investor psychology. I don’t foresee any upward pressure on interest rates unless there’s a true financial panic. Even if there were a panic, there are so many trillions of dollars invested in U.S. Treasury securities that there is nowhere else for them to go. Accordingly, absent an end-of-the-world type scenario, I believe interest rates are a neutral influence at worst, and probably slightly positive.

Next are corporate earnings, which have been surprisingly good of late. Yet, I believe the outlook for the U.S. economy – and all others that are at least partly reliant on it, which is everyone – is worse now than it was before the manufactured debt ceiling crisis. That political stunt by Tea Party fanatics shook people’s faith in the American political system, and raised doubts about the American economy that weren’t there before. As a result, more people are talking about a double-dip recession now than before, and such talk tends to become self-fulfilling. Moreover, falling stock markets tend to make people feel poorer, which makes them spend less, which slows demand, which slows the economy. All told, then, I would have to assess corporate earnings as being neutral at best from here, and possibly negative.

Finally we come to investor sentiment, which is always the hardest to get a handle on. Moreover, if the markets have a couple of high-flying up days, then psychology can change from being deeply fearful to being deeply greedy overnight. But one solid indicator of market sentiment which has been consistently good is market volatility. High volatility times, even when markets are rising, are times when there’s lots of uncertainty, which is why values seem to change overnight. The best environment for bulls is one where markets make a slow, steady advance, not ones where markets zip up, then down, then up again. And a handy index for this is the Chicago Board Options Exchange SPX Volatility Index, or VIX index (VIX:IND). This index recently reached levels unseen since April of 2009. All told, then, I would suggest that market sentiment is unsettled and nervous, which is definitely bad.

So could markets surprise us on by running away from us on the upside? There’s always that possibility, but I think the odds are pretty small that we will lose a lot by staying on the sidelines. If the market recovered to where it was in May, the S&P 500 could go back to 1360, which would mean we might miss a gain of about 22%. And that’s if the market took off so fast we couldn’t respond. So the risk of being left behind by the market is, in my view, relatively limited.

Possible Positives

Another positive development is that falling stock prices have also brought down commodity prices, notably oil. Since high oil prices act like a tax on the economy, lower oil prices clearly benefit economic growth.

And banks are generally in much better financial condition now than they were in 2007 – except those that have loaned too much to weak European sovereign credits.

Beyond these points, what might is likely to happen to the economy? Well before the phony debt crisis, the outlook for the U.S. economy was disappointing at best, with feeble growth, weak employment, and nothing on the horizon promising to change that. Now the outlook is worse, as I said, so at best we could see the economy return to that slightly depressing, feeble outlook. So, again, the potential to be surprised on the upside, or the return half of the equation, seems limited. Now let’s turn to the potential risks. Alas, here the list is much longer and more compelling.

Potential Negatives

I’m going to list the risks, and merely touch on most of them rather than go into exhaustive detail. The prospects are dreary enough without dwelling on them. I’m going to save the worst ones for last. Here are the major risks that I see now:

• Stocks go down because they go down. Markets develop a mind and momentum of their own, and while I don’t believe you should ever rely on momentum investing, it’s also clear that when investors become fearful, and especially when they panic, it’s dangerous to get in their way. In particular, investors, particularly boomers hoping to retire, were deeply shaken by what happened to their investment portfolios in 2008, and are likely to be faster to bail out on markets rather than try to ride them out. This increases volatility, which, as I’ve said, is a bad thing.

• A possible double-dip recession. There is no real reason why the U.S. economy should go back into recession. I had been expecting it to dribble along in a slow growth, jobless recovery that was disappointing. Now, though, the talk about a double-dip is, as I said, likely to become self-fulfilling. There’s no fundamental reason for it, but the phony debt ceiling crisis shook confidence, and ultimately the economy. And the markets run on confidence.

• America’s downgrade from AAA. This doesn’t help, but it is currently a split rating, with only Standard & Poor’s lowering America’s credit rating, and only on long-term debt. If the two other major agencies, being Moody’s and Fitch’s, were to follow suit, that would be an enormous negative, but that doesn’t seem to be in immediate prospect. Neither, though, is America likely to get its AAA rating back anytime soon. Canada was downgraded from AAA in 1992, and then got it back ten years later. But that was during a period of strong economic and productivity growth, and the Government of Canada, under Prime Minister Jean Chrétien and Finance Minister Paul Martin ran 10 years of budget surpluses, paying off big chunks of government indebtedness. The odds of America doing that are vanishingly small. The only reason American debt has performed as well as it has so far is because, in the words of one commentator, “It’s the best looking horse in the glue factory.”

• Weak economic growth compounding American government indebtedness. The Tea Partiers have overlooked the primary fundamental of government finance: that government revenues and expenditures are inexorably tied to economic performance. A weak economy will sap government revenues and force up expenditures, compounding deficits, and piling up debts. Slashing spending in such an environment cuts jobs, lowers economic growth, and increases deficits. This is precisely what happened in the 1930s under President Herbert Hoover. He and his counterparts in Congress kept slashing spending to try to bring the deficit under control, only to find that economic growth fell further, increasing the deficit. In response, they slashed spending even more. It became a vicious cycle, and this is still the textbook example on how a government can turn a recession into a depression. Unfortunately, right-wing politicians in America seems to be embarking on precisely the same policies now.

• Another negative that has ramifications that go far beyond stock prices is the high rates of unemployment for men and young people. We can see the results in the riots in Greece and Portugal, but now in London as well. In America, the official unemployment rate is 9.1%, but the percentage of working age (16 to 64) American men who are employed has fallen from about 85 percent in the early 1950s to under 65 percent now. Some put the actual unemployment rate of men in America at 25%, and that for young people at 45%. These numbers are hard to confirm, because unemployment surveys don’t include people who are so discouraged that they’ve given up even looking for work. Whatever the true numbers are, this is bad news economically, bad news socially, and bad for America’s future.

• The political deadlock in the American Congress. America has become steadily more polarized over the past 20 years. There have been many analyses of why this is, but I think there are two primary reasons. First, the media have discovered that it is more profitable to be biased and outraged than it is to be balanced and thoughtful. Fox News in America, and News of the World in England are or were the exemplars of this trend. And with the splintering of media caused by the Internet, people can now choose to consume only those viewpoints with which they agree. This creates the echo chamber effect, where like-minded people reinforce their own prejudices. The result is rather like being surrounded by yes-men: you become convinced that your point of view is the only valid one. This pushes people with different viewpoints farther apart, and causes them to summarily dismiss any views that don’t coincide with theirs as being obviously, even maliciously wrong.

The other reason is jerrymandering. As I’ve discussed this at length in another blog (found here), I won’t go through the arguments again. But the result is that the extremes in American politics are being over-represented, and the center is being ignored. According to The Economist newsmagazine (14 April 2011), the results are pretty stark: “On average, House Republicans have voted with their party’s majority 91% of the time and Democrats 90% of the time. The picture is very similar in the Senate.” This is making American ungovernable, as was clearly on display during the unnecessary debt crisis, and an America that cannot govern itself becomes a danger to itself and others, geopolitically as well as economically.

• Finally, the greatest immediate risks out there right now relate to the financial crisis in Europe. Greece is functionally bankrupt, and all that is left is to decide how to cope with the financial mess. The other weak members of the EU are being shunned by the credit markets with more or less justification, but the net result is a potential run on European sovereign credits. The results of this could be very much like the run on Bear Sterns or Lehman Brothers in 2008, with the same kind of knock-on consequences. Worse, this financial crisis could lead to the possible collapse of the Euro as a currency, which would endanger the survival of the EU. And that would be a very big economic (and financial) shock indeed, especially as the world’s central banks don’t have as many resources left to battle a global financial crisis.

The Costs of Being Wrong

So the cost of being too pessimistic is the potential to lose a market gain of perhaps 20-25%. The market cost of being too optimistic would be a repeat of the kind of bear market we saw following the 2008 market panic, which could be a further 40% drop. But the greatest risk is that the problems in Europe and America are compounded by policy mistakes, such as those followed by Herbert Hoover in the 1930s, or a market collapse brought about by forces that overwhelm the world’s central banks, such as the collapse of the European Union with the subsequent economic catastrophe. Either of these could produce a market drop similar to that of the 1929 to 1932 period, which was a fall of 89% would take the S&P 500 down to the vicinity of 170 points – an 85% drop from where it was when I started writing this blog. That, and the very dangerous economic fallout that would come with it, are the real risks.

So if you’re only mildly pessimistic, weigh the potential for a 25% gain against a 40% drop. If you’re really scared, weight that 25% upside against an 85% downside. Add in your assessment of the probabilities of each, and place your bets accordingly. As for me, at the moment, I’m staying on the sidelines and watching the carnage, biting my fingernails all the while.

My last blog dealt with the debt ceiling debate within the U.S. Congress – if “debate” is the word for what looks like a combination of Mexican stand-off and Russian roulette. I’d like to update my comments with some things to watch:

1) August 2nd is probably not the deadline. I believe the actual deadline is unknown, and uncertain. If the rating agencies drop the credit rating on US debt, or the markets start to panic, that will start a chain of events that will probably be irreversible, and trigger a US default. Yet there is a real danger that all three parties involved in this mess (Republicans, Democrats, and the President) actually believe that they have until August 2nd to back away from the abyss. In fact, the ground may collapse under their feet while they’re still posturing on the edge.

2) Suppose that the Speaker of the House of Representatives (John Boehner) and President Obama do arrive at a deal in time. What they may not be counting on is hold-ups by others, such as a defeat of their deal by ideologues within the Republican party in the House, or a filibuster by a disgruntled ideologue of either party in the Senate. This could prevent a deal from passing in time, and could trigger the events described in point 1 above.

3) Even if a deal is struck before panic happens, this event has already caused significant damage, and we won’t know the extent of that damage for months or years. As one of the commentators I follow, a retired money manager who keeps tabs on things for his own interest, put it in an email to me: “a great deal of damage has already been done. Anyone who would have said a year, or even six months ago, that there would be major talk of the US defaulting would have been laughed out of the room. Foreign investors, incl. the central banks, are already ‘voting with their feet’, as witnessed by the price of gold that this morning leapt through the 1,600 level and the fact that last week was the 16th month in succession that assets under management dedicated to emerging market bonds funds were up.” In effect, the United States government has called its own credibility into question, and announced loudly to the world that it is dysfunctional and untrustworthy on financial matters. US debt is no longer “risk free”, and investors will hereafter try to find other, less schizoid places for their money, which will cause U.S. interest rates to rise, further exacerbating the U.S. deficit by increasing interest costs. This is an incredibly dumb action by the U.S. Congress, notably the brain-dead ideologues in the Republican Party.

4) There are members of the Republican party that are saying they won’t vote raise the debt ceiling under any circumstance, which is an ideological statement, not a rational one. There are Republicans who are saying a default would not be as bad as Obama is saying, that he’s fear-mongering. That’s a clear illustration of their ignorance. There are even Republicans who are saying that default would be a good thing because it would force liberals to cut spending – completely overlooking the fact that it would dramatically raise the interest rates the US government would pay, which would raise the total interest costs, which would increase the deficit. It is truly frightening that our collective future is at the mercy of such idiots. Moreover, if a default happens, these same idiots will blame Obama because they always blame Obama.

5) There are only two small pieces of good news of the last week or so. First is that while the American public is condemning all sides on this issue, its greatest condemnation is for the Republicans fanatics. Hopefully this will scare them enough that they will rethink their positions. The other is the bizarre, Rube Goldberg-ian mechanism proposed by Senate Minority Leader Mitch McConnell. In effect, it would allow Republicans to vote to give Obama the power to overrule them and raise the debt ceiling. They think that this is somehow different from voting to raise the debt ceiling. The only thing to recommend this wacko idea is that it might lead to the debt ceiling being raised, and rescue the Republicans from themselves.

6) So far, most Democrats have been remarkably silent (or at least unnoticed), but I suspect that some left-wing ideologues will say they won’t vote to raise the debt ceiling if Social Security, Medicare, or Medicaid are affected by cuts. These people are as dangerous as the Republican fanatics. The US has no choice but to cut its deficit, as I’ve written elsewhere. Any such Democrats are idiots, too, if they hold to this position.

7) Some have suggested that President Obama has the power to raise the debt ceiling without Congress by virtue of Section 4 of the 14th Amendment, which says “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” First, I don’t find this unequivocal, but more importantly, how many investors would be willing to take a chance on buying debt that may not be legal, and might subsequently be declared invalid by the U.S. Supreme Court? I think this is a non-starter.

8) The financial markets aren’t reacting more because they don’t think that the Republicans are serious about refusing to raise the debt ceiling, while the Republican fanatics assume that the markets don’t care. Meanwhile, the bond market is torn because investors are so concerned about what’s happening in the EU that many are fleeing to US Treasury issues. Where else is there to go? Both of these effects leave the impression that things are better than they actually are – and may given the parties involved in negotiation more time before a panic occurs.

9) Most of the reactions I’ve had to my blog have been wishful thinking, along the lines of “This can’t happen. This is all posturing. They’ll come to an agreement.” I certainly hope so, but I’m not seeing signs of it. I can only hope that there is real progress being made in the back rooms on this, because everything I see in public pronouncements indicates two sides that are too far apart to reach a deal. And, by the way, through this and other of my blogs, I’ve been ripped as being both a tool of the Republicans (by liberals), and a tax-and-spend liberal (by conservatives). I guess I must be doing something right.

Possible calendar of events to default – or avoidance thereof

Let me offer a possible timetable of events for avoiding a default. Anything worse than this must, I think, lead to default. Anything better may avert it, although that’s not certain:

Thursday, July 21st, 2011 – Markets begin selling off in earnest as time runs out to craft, draft, pass and sign legislation permitting the debt ceiling to rise. (Foreign exchange markets are already starting to move.)

Monday, July 25th, 2011 – One or both of the rating agencies offer one last warning, saying that a ratings downgrade is imminent unless a deal emerges to raise the debt ceiling. As well, both agencies emphasize that raising the debt ceiling alone is not enough; the deficit must be tackled in a realistic manner as well.

Wednesday, July 27th, 2011 – Congressional leaders and President Obama announce the outlines of a deal, forced on them by falling markets, plus a fast-tracking process to get it through both houses of Congress in time. Markets have dropped by about 8% from a week earlier, or more than 1,000 points on the Dow Jones Industrial Average.

Friday, July 29th, 2011 – Grandstanding Republican fanatics try to stall or fatally amend the legislation, but are slapped down by Republican leadership. The bill clears the House.

Monday, August 1st, 2011 – Members of both parties attempt to filibuster, delay, or fatally amend an identical bill in the Senate, but are voted down by combined Republican and Democratic Senators. The bill clears the Senate.

The bill goes to Obama to sign. He signs it with the media watching, and thanks leaders of both parties and in both houses of Congress. He also announces a task force with members from both parties to come up with $1.5 trillion in budget cuts and revenue increases over the next 10 years, such cuts to be enacted by the end of 2011, plus a secondary goal of recommending budget cuts and tax code revisions amounting to $4 trillion over the next 12 years, to be enacted after the elections of 2012.

The Federal Reserve announces a special debt issue to provide the government with immediate cash, which it purchases from the Treasury, pending a successful new public bond issue. Critics call this “QE3”, but it’s really about the only way the Treasury can get enough money fast enough to meet obligations – by having the Fed print it.

The markets rally slightly, then begin sinking again more slowly on the continuing crisis in Europe and the weak economy in America. Moody’s and Standard & Poor’s maintain their negative watch on the US credit rating.

—————–

Is this the way it will happen? Certainly not. First of all, I don’t know enough about the process of passing legislation through the US Congress, but I do know that the Treasury Secretary has said they must have a deal by July 22nd in order to get the legislation done. Moreover, there are too many aspects of this very complex future for me to successfully get them right. What I’ve tried to do is come up with an at-the-last-moment scenario to use as a benchmark to see how the process is going. As I said, if the process lags behind this, then a default seems likely.

Just so you know, I am backing my words with actions. I have, at this point, sold or am in the process of selling all of my investment holdings except for (a) precious metals, and (b) a small investment in developing economies. I may sell both of these positions before the dust settles. I am also trying to minimize my holdings of US dollars.

© Copyright, IF Research, July 19th, 2011.

The world as we know it may very well end on August 2^nd. This won’t be the end of the world in a metaphysical or spiritual sense, but rather in a financial and economic one because of the incredible, almost unbelievable stupidity of the extreme members of the Republican Party. These wing-nuts are using the financial equivalent of the threat of nuclear winter to negotiate their agenda of spending cuts, coupled with no tax increases or even tax cuts, to eliminate the U.S. federal deficit, or else. In this case, the “or else” is a refusal to raise the debt ceiling for the U.S. government. If that happened, then the U.S. government would run out of money by about August 2^nd, and begin to default on its obligations. There are two major aspects of this: financial, and political. Let me deal with the financial aspects first.

The debt ceiling is the maximum amount of debt that the U.S. government is allowed to borrow to finance it’s operations, and is legislation originating in the House, approved by the Senate, and passed by the President, like any other financial legislation. The U.S. government cannot borrow any money beyond this authorization. Given the current massive deficit being run up by the American government, this would force the U.S. government to default on its debt. Such a default would produce a vast disruption in the financial markets, and cause America’s credit rating to be downgraded from AAA to AA or less. This, in turn, would require many pension funds and other investment groups required to hold nothing but AAA securities to sell all of their holdings in U.S. government bonds and T-bills. This forced sale would trigger a panic on Wall Street, and in financial centers around the world. U.S. treasury bonds and T-bills are considered the most secure investments in the world – but then, suddenly, they wouldn’t be. Investors would have no idea what was safe, or where they should put their money. And the amount of U.S. securities held by investors, including countries like China, runs into the trillions. If there were a run on U.S. securities, it wouldn’t just be dramatic, it would be cataclysmic because there would be nobody to buy them.

And it wouldn’t just be the U.S. federal government. All of its agencies and the agencies it supports would be downgraded (and their securities dumped). And it’s quite possible that a number of state governments would also be downgraded as well. Indeed, as anyone who has studied financial panics of the past (as I have) knows, once a panic starts, the mob sells anything with any hint or rumor of possible financial difficulties. As a result, the panic would instantly spread to all of the shaky sovereign credits of Europe (Greece, Ireland, Portugal, Belgium, and more), and move into American state governments (Illinois, California, and more), and into corporations thought to be less than rock solid. Eventually, everything would become suspect, and gold and precious metals would shoot through the roof.

This would cause a huge spike in interest rates, causing stock prices to collapse, and, worst of all, would critically damage investor confidence. Since all investment markets rely on confidence, this could produce a panic as severe, or worse, than the panic that seized Wall Street in October of 2008. Worse than that, there would be no U.S. Federal Reserve to save the markets from themselves. They wouldn’t have any money with which to operate, and whereas the U.S. government was seen as the only possible savior in the Panic of 2008, it would be the cause of the problem this time. With no one left to act as “lender of last resort,” it’s entirely possible that financial markets around the world would collapse, possibly triggering a depression on the scale of the 1930s or worse. We really do not know how bad it would be – only that it would be unprecedented, and very, very scary.

But if the consequences are potentially so extreme, why are the markets not reflecting this? Let’s run over the potential counter-arguments.

“This is all just negotiating tactics. They won’t allow a default to happen.”

Perhaps so, but playing chicken while driving a truck full of nitroglycerine over rocky terrain doesn’t leave you much room for mistakes. Moreover, I’m not sure that the players involved are smart enough to understand the magnitude of the problem, and they could easily misjudge the situation. Even if they are planning to come to a last minute compromise, it’s not clear that the markets will wait that long. The rating agencies have already warned that if they don’t see a settlement by mid-July, they could downgrade U.S. securities, even without a default. Since a negotiating posture is only effective if you make the other side believe that you’re serious, the Republicans will have to act as if they are prepared to allow a default if they don’t get what they want. In so doing, they may also convince the rating agencies of the same thing, triggering the kind of run on Treasuries that I described above.

Moreover, the markets might get spooked before the rating agencies can act. The thing that scares investors most is uncertainty. If the biggest, most important financial entity in the world suddenly looks shaky, investors might suddenly decide that they need to run for the hills. Once a panic starts, it would be very difficult to stop.

“The U.S. government can’t possibly be this stupid. This is all show. It’ll blow over.”

Not true, and there’s precedent to prove it. On June 17^th, 1930, President Herbert Hoover signed the Smoot-Hawley Tariff Act of 1930 into law, raising tariffs on 20,000 imported items, and triggering a massive trade war that caused global trade to drop by two-thirds in a period of four years. Yet, Hoover had been warned by over 1,000 of America’s most eminent economists. He had been intensively lobbied by Henry Ford, who called the bill “economic stupidity.” The CEO of banking giant J.P. Morgan begged Hoover not to sign the bill – but he did, for political reasons.

Make no mistake, this is a very, very dangerous situation – a big, honkin’ Black Swan if there ever was one – that is comparable to the massive error of passing Smoot-Hawley. So don’t count on the government coming to its senses. History argues that governments sometimes do stupid things for ideological and political reasons.

“You’re exaggerating. The effects of a temporary halt in payments couldn’t possibly be this extreme.”

Who knows? This has never happened before. Once the U.S. government has failed to live up to its responsibilities for any reason, and for any period of time no matter how short, it will be impossible to regain the “full faith and credit” of a borrower that is beyond suspicion. Indeed, the rating agencies have a policy of automatically downgrading the ratings of a borrower that fails to live up to all of its obligations, if any investors lose money through delayed or halted payments of interest or principal. At time of writing, for instance, Standard & Poor’s has just warned that if Greece extends the payment schedule on its debts, as is being discussed within the EU as a possible solution to Greece’s debt problems, that would constitute a default and trigger a downgrade. And the rating agencies are still smarting from being accused (correctly) of not being tough enough on issuers in the asset-backed securities markets prior to 2008. They won’t want to be seen to be committing the same mistake again so soon, regardless of the consequences.

Perhaps I’m wrong, but as a former credit analyst, and one who used to assess sovereign credits for a living, I don’t believe I am. Moreover, those who pooh-pooh the consequences have no basis or evidence for their assertions. It is wishful thinking, pure and simple.

“This is nonsense. It can’t happen. They won’t let it. This just isn’t possible.”

Who’s “they”? This is just more wishful thinking, and is comparable to pulling the covers over your head to ward off danger while the house is on fire.

“You’re being irresponsible by talking about this. You’re going to create a panic by doing so.”

No, the irresponsible, brain-dead idiots at the extremes of the Republican party are running that risk. I’m just talking about the potential consequences of their actions. Besides, I’m not the first, nor am I the most important person to discuss it. The rating agencies have issued very forceful (for them) statements on this. The Chairman of the U.S. Federal Reserve, Ben Bernanke, has said this is dangerous folly (although not in those words). The International Monetary Fund has warned that this is an irresponsible and exceedingly dangerous path that could cause a “severe shock” to the American and global economies. The current Secretary of the Treasury, Tim Geithner, has said that it would be “catastrophic”, and even one of George W. Bush’s economic advisors, Keith Hennessey, has publicly said that he’s “terrified” at the prospect. I doubt if my comments will make much difference – except to my readers. For them, I hope it helps them prepare contingency plans in case the unthinkable happens.

“A default would actually be helpful, as it would force America’s government to face the reality of its financial position.”

Nope. As I’ve already said, it would trigger an absolute panic and bankrupt the government, which would then be forced to make long-term policy on the basis of emergency conditions. It would have to make bad choices, possibly even very bad choices, because better choices would no longer be available. Tackling the deficit is going to be tough. Trying to do it while simultaneously trying to keep the global financial markets and global economy from complete collapse would be impossible. This is just a bad idea.

“This is Obama’s fault. He’s the one that’s being unreasonable. We have to bring down the deficit, and this is the only way to force liberals to cut spending.”

Presidents and Congresses have disagreed about critical issues before, but no one has ever used the debt ceiling as a threat, and it is the Republican extremists that are doing so. This is on all fours with strapping a bomb to your chest, and threatening to blow everyone up if you don’t get exactly what you want. It’s no less threatening, and no less extreme than that, and it is Republican extremists that are doing it, which brings me to the political dimension of things.

I grew up in the Republican party. My father was a die-hard Republican, and I was raised that way. I voted that way when I first started voting. Since then, I’ve voted more discerningly and hopefully more thoughtfully for candidates that I thought were the best (or least-worst) choices, both Republican and Democrat. But this is not my father’s (or my) Republican party. The current Republican party seems to have been captured by fanatics who believe that ideological purity is more important than reality. They are spoiled children, throwing a tantrum to get what they want, and endangering us all in the process.

And those who have regularly read my blog know that I believe the U.S. budget deficit must be tackled, hard choices must be made, and sooner rather than later. But what the Republican extremists are demanding is that a process that should be thoughtfully devised, then carefully negotiated, and implemented over a period of years in order to minimize the necessary harm inflicted must, instead, be accomplished overnight, and that all the costs must be borne by someone else’s constituents, not theirs. Some of these extremists have even demanded tax cuts be part of the deal, even though such cuts would increase the deficit, not decrease it. They are clinging to an ideology as defunct as Soviet Communism, and pointing to the Reagan tax cuts as being self-financing, even though Reagan’s own budget director, David Stockman, has said that tax cuts in today’s environment would be a bad mistake. Indeed, in talking about extending the Bush tax cuts during the 2010 debate, Mr. Stockman said that the Republican position was “Utterly disingenuous. I find it unconscionable that the Republican leadership faced with a 1.5 trillion deficit could possibly believe that good public policy is to maintain tax cuts for the top 2 percent of the population”.

But extremists don’t want to hear that, and so they don’t listen. They have substituted ideology for thought or reason. They are ideologues as blind as any group of religious fanatics, except they could cause much greater harm to a much larger group of people, both at home and abroad.

“Forcing the government into default is the best way to make sure we’ll beat Obama in 2012.”

I haven’t actually read any reports where someone has said this, but some Republicans seem to be thinking it awfully loudly. If I’m right in thinking this, then it is a morally bankrupt attitude, verging on treason. It amounts to saying that you are willing to crash the American economy, trigger a collapse of the world banking system, and bankrupt many American citizens for selfish political gain. It would be like deliberately losing a war in order to win the presidency.

“So, what should we do about it? If the situation is as bad as you say, what’s the answer?”

Now we come to the reason for this blog: to offer some thoughts about what individuals should do to prepare for this possible black swan event.

The first thing to do is to hope that the participants are more intelligent than I give them credit for, and resolve this issue quickly, before they spook the markets or the rating agencies. If they wait too long, it may be too late, so August 2^nd (or sometime that week) may be the outside deadline; the markets might panic before than. And writing to your Congresscritter wouldn’t hurt. Tell them that Congress & the president need to come up with a credible plan for reducing the deficit through painful spending cuts, tax increases, and especially through reductions to Social Security & Medicare entitlements, but that not raising the debt ceiling is not a legitimate negotiating tactic.

Next, watch the news for developments. Assuming that we can’t influence the participants (and they seem impervious to argument no matter who offers it), then you need to prepare yourself for the worst. You needn’t do it all at once, but make sure you stay ahead of the market’s perception of a crisis. And this is where systematic risk management comes into play.

In this situation, we are running two opposing kinds of risk: the risk that there will be a panic, market collapse, and massive recession or depression; and the risk that the U.S. won’t default, that a crisis will be avoided, and the markets will continue to advance. Let me deal with the second risk first.

If a crisis is averted, and the world carries on with business as usual (which is what I devoutly hope will happen), then the market will carry on as if nothing important happened. As the stock market has been rising of late, it’s possible that if you sold holdings in advance of a possible crisis, you could forego potential capital gains by liquidating your holdings. This is a potential opportunity cost, but not a large risk. Suppose the S&P 500 were to regain its previous 2008 high before you could manage to buy back into the market. This means it would have to run up by about 16% in a very short period of time. So, on the extreme high end of things, the second risk is that you might forego about a 16% gain from where we are today – and that’s assuming that the market keeps going up, and actually goes up much faster than it has of late. I think this is highly unlikely, but let’s leave it at that: the risk of missing an upside move by the markets is foregoing a 16% increase in your portfolio.

The Default Risk

Now let’s consider the first risk: that, intentionally or not, by August 2^nd or somewhat before or after, the U.S. government defaults on its obligations, and that triggers a panic. What would be the financial risk if you don’t prepare for that possibility?

Well, first, how far might the market fall? In the market panic of 2008, the S&P 500 fell more about 54% from its October 4^th high. The stock market crash of 1929 was slightly worse, with the Dow Jones Industrial Index (“DJII”) falling on the order of 58%.

But the initial market crash of 1929 is not the biggest risk; the potential for a prolonged severe recession or depression is. Indeed, the stock market decline from 1930 to 1932 was actually worse than the crash of 1929, with the DJII falling 79% from the market low of 1929 to the market bottom in 1932. All told, from the 1929 high to the 1932 low, the DJII lost an incredible 89% in value. And that is, in my opinion, the comparable risk investors run from a potential default, aside from any economic damage they might incur, such as losing their income or their home.

So, now we come to the issue of risk assessment: Which is the greater risk? Missing out on a potential 16% investment gain from here, or losing 89% of the value of your current portfolio from here, plus experiencing significant economic suffering? Remember that the markets are largely ignoring the closed-door discussions on raising the debt ceiling, so that if a deal is announced, it is unlikely that the stock market will blast off to that 16% gain in a short period of time, whereas if a default occurs, everyone will thunder for the exits at the same time. In my mind, there is no comparison: it is far riskier to ignore the potential for a default than it is to forego the potential for gain.

So What Actions Should You Take to Prepare?

If you concur with my assessment, what do you sell, what do you buy, and how do you prepare? I’d start by selling investments that have done well for you, but may have limited upside from here. You can always reinvest later if the crisis passes. If the days tick by, and there is still no word of settlement, I’d start selling more earnestly, including things that perhaps you don’t feel have done as well as they should. Remember that the rating agencies have warned that they are expecting to see a settlement by the middle of July. If no such signals emerge, they may start being more vocal, and the markets may become more unsettled.

If, by the third week of July, there is no sign of a settlement, and the two sides continue to say they are deadlocked, it’s time to take serious defensive action. Sell any investment that is not a disaster scenario holding. Perhaps even sell money market funds to hold cash. And check the terms and conditions on your financial accounts. Following the banking crisis of the Great Depression, financial institutions added clauses that give them the option to require 3-5 day’s notice of a withdrawal. Just because they have waived that requirement for almost 80 years doesn’t mean that it’s not there, so check with your banker or broker.

In the extreme, if it seems likely that a disaster is going to happen, think about what you think will hold its value. This starts with gold & precious metals, but also think about how you want to hold it. If you have investments in a mutual fund that invests in precious metals, and the company that runs that fund goes bankrupt, what will the value of your holding be? Cash is likely to be worth having, or being able to get hold of quickly – but who’s cash? Do you want US dollars? And always keep in mind safety. Do you really want to have bunches of cash under your mattress? What about the risk of fire or theft? How do you want to deal with that? These are issues that deserve some serious consideration.

And if a deal is struck “at the last minute” (whenever that might be), and there is no default, and no run on the markets, then what? Then you take a long look at the risks as they are at that time, and, if you’re convinced that the risks are now on the upside (i.e., that you might lose more by missing a major market advance than remaining on defense), then unwind your defensive positions, and go back to your investments.

If I’m overreacting to the potential risks, and life goes on as usual instead, it will have cost you some money in transaction costs, and you might possibly forego some upside on your investments. If I’m correct in my assessment of the risks, then taking a defensive position may make the difference between financial survival or not.

And, for the record, I sincerely hope a deal is struck. I may wind up looking foolish, rather like Chicken Little screaming that the sky is falling, but I would prefer that result to the horrors of being proven right. If it’s a choice between pride and survival, I’ll pick survival. But I’d be prepared for either one.

© Copyright, IF Research, July 5th, 2011.

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If we’re lucky, 2010 could be a lousy year. If we’re unlucky, 2010 could be a disastrous year, worse than 2008, because there are potential nasty surprises lurking out there. Such surprises could precipitate another, even worse financial crisis, and dump us into a global depression, instead of the recession from which we are now emerging. I’m going to deal with the issue of the nasty surprises in a later blog, so just for the moment, I’m going to assume that none of them will happen, and the economic future will unfold about as it looks now. And, although I’m looking out to the year 2020, I’m going to start by looking at 2010 on its own before moving beyond there.

The Prospects for 2010

America is out of its recession, but I would hesitate to call what we have now a recovery. It’s true, U.S. GDP grew by a reported 3.5% in the third quarter of 2009, but that was, in many ways, misleading. In the first place, it was heavily influenced by government stimulus, especially the “cash for clunkers” program. Since government stimulus will be tapering off in 2010, and the car incentives are finished, this source of economic strength will be missing. But even more revealing, barely was the ink dry on the reports of 3.5% GDP growth when they were revised downwards to 2.8% – an unusually large and rapid downward revision.

To see what’s ahead for the U.S. economy, let’s start with public sentiment. One of my favorite indicators of economic strength is the frequency with which the word “recession” appears in the mainstream media (“MSM”). This indicator has been known and used for decades, but before the Internet, you had to be in the MSM to have the ability to perform this count. In 1995, I realized that I could do it myself using Googles’ news website, and since September of 1995, I’ve done just that every week, and then graphed the results. Here’s how this graph looks today (the X-axis has been inverted since “recession” is inherently a negative idea):

© Copyright, Richard Worzel, December 2009.

One of the interesting things about this indicator is the date when it said we felt the best about the world, which was July 30th, 2007. This was just five months before the indicator dropped suddenly at the beginning of 2008, indicating that concerns were rising. This subsided in the Spring of 2008, but then collapsed in earnest in October of last year – a trough from which we haven’t yet recovered. Clearly, we were all feeling fat, dumb, and happy in mid-2007, without realizing how bad the underlying fundamentals were. And the most important lesson to draw from this is that sentiment indicators are not good predictors of problems, only feelings.

Yet sentiment is important. It embodies what economists call the “animal spirits” of an economy, being the courage to go out and do things, like take risks to make and spend money, and the willingness to trust that the other side of a transaction can and will fulfill their part of an agreement. Without these feelings of courage and trust, people hunker down in a hole, don’t spend money, and the economy’s heartbeat stops, which pretty much describes what happened last year.

Now, looking at the chart again, we can see that although our “animal spirits” have recovered from the depths, we are nowhere near where we were at the beginning of 2008. We’ve climbed back, but seem stuck halfway – and that’s a pretty fair estimate of what I expect for 2010. The economy will grow – but slowly. Unemployment will stop exploding, but employment will be painfully slow in coming back. Indeed, employment typically is slow to return at the beginning of a recovery because business owners are still wary of potential problems, and because they can increase working hours, through additional shifts and overtime, without hiring additional staff. This increases productivity and profits without increasing risks – a good bet in perilous times, but tough on those out of work. So, the prospects for America’s economy in 2010 are weak, at best.

Despite this, the outlook for inflation is dismayingly bad. I consider the price of oil to be the bellwether of rising prices, because of its pivotal position in the global economy. The price of a barrel of oil dropped from $147 to $30, and has bounced back to over $70. Now, it’s true that $30 a barrel was clearly an overreaction by a market that was wondering if the world was coming to an end, but you still have to ask why it would bounce back so far and so fast. The answer, as it often is in this day and age is simple: China, India, Brazil, and the other Rapidly Developing Countries (RDC’s). They barely went into recession, or merely experienced growth slowdowns, which were over relatively quickly. As their economies bounced back, their thirst for oil began growing again. And when the developed country economies begin growing again, all of the bottlenecks that caused the price of oil to spurt upwards in 2006 & 2007 will come into play again, and the price of oil will, once again, spurt upwards, stoking the next inflation cycle. And because of the growing relative importance of the RDC’s in the global economy, we will all experience more inflation much earlier than we would normally expect in this economic cycle.

This same combination of RDC growth and developed world recovery will play out again and again beyond oil. Food will be one of the next places it will happen, followed by other commodities and resources. The net result is that we will start hearing about an indicator that went out of fashion in the 1980s: the “Misery Index.” The Misery Index is the unemployment rate plus the inflation rate, and reached an annual high of 20.76% in 1980[1]. For comparison, it reached a modern low in 1998 at 6.05%, and its post-World War II low was in 1953, when it was 3.74% If America’s unemployment rate sticks somewhere around 10%, which I expect it will, and inflation reaches 5%, which it might despite the weak U.S. economy, then the Misery Index will reach 15% – a level not seen since 1982 when Ronald Reagan was president. All of which is why I say that if we’re lucky, 2010 will be a lousy year.

Canada’s 2010 – Canada will have an uneven year, which is to say that some parts of Canada will do quite well, while others will continue to suffer. Most of the suffering will be done in Central Canada – Ontario & Quebec – because of their reliance on manufacturing, especially in cars, their overwhelming ties to the United States, and the strength of the Canadian dollar. All of these mean that the two former powerhouses of the Canadian confederation will now lag most of the rest of the country in recovery. Indeed, if the loonie continues to strengthen against the greenback, Central Canada could have an even worse year than the United States.

Meanwhile, those provinces that supply natural resources, particularly Alberta and Saskatchewan, and to a lesser extent B.C. and Newfoundland, will do much better. With oil strengthening, and food following, the two Prairie provinces will build on their previous strengths and outperform the rest of Canada, as well as the United States, and their strength could continue to boost the price of the loonie. The resource provinces will also increase their trade with the developing countries of the world, notably China. Indeed, I would suspect that we will see a return of corporate takeovers of Canadian resource companies that could cause the Toronto Stock Exchange to outperform most developed world counterparts in 2010.

All of this will add political friction between the new “have” and “have-not” provinces that will make life testy and interesting in Parliament in Ottawa.

RDCs – Meanwhile, the RDCs, again lead by China and India, but also including Brazil and to a lesser extent Mexico, Malaysia, and Indonesia, are bouncing back from a fairly traditional inventory-led recession or growth slowdown.

There is more to RDC growth than China. Everyone has heard of India, and India will continue to try to accelerate its growth. However, watch Brazil as well, which is becoming the next powerhouse after having settled its long-standing problems of political and economic stability. We will be hearing more and more about the giant emerging in South America.

China’s ambitions – One particularly important issue for the future is China’s pegging of its currency to the U.S. dollar, which means that it has effectively executed a competitive devaluation against the Euro, Yen, and other currencies while maintaining its undervalued status against the greenback. This will cause the U.S. trade deficit to continue to run unsustainably high, and will inflict even more damage on other developed country economies. This is not the behavior of a player concerned about its image in the world, or even in its own long-term enlightened self-interest, but it does accord with my beliefs about what motivates China.

I believe that China has two primary objectives that trump all other concerns; one immediate, and the other long-term. The immediate one is the Chin’s leaders are desperate need to keep economic growth high in order to keep employment growing. If they aren’t able to achieve at least 8% growth in real GDP per year, then by their own reckoning, unemployment will rise, and with it, social and political unrest. And, from what I’ve seen, China’s leaders are more concerned about hanging on to their political power – which means political stability – than anything else. The welfare of its trading partners pales into insignificance in comparison to this critical domestic need, especially when you consider that in 2007 – the last year of strong global growth – China experienced a reported (but unverified) 10,000 spontaneous demonstrations about economic and living conditions around the country. The Red Army may be large, and it may be strong, but it can’t be everywhere, so political instability scares China’s leaders like nothing else. Accordingly, if China’s economy needs exports for strong growth, then it will contrive to have exports at any cost, especially if someone else pays that cost. China is not the first country, or the only country to play the trade game entirely selfishly. Indeed, you could say they’ve stolen Japan’s playbook from the post-war era. But China is playing it very well, if cheating for narrow self-interest is your yardstick.

The second motivation is long-term: China wants to dominate the world, replacing America as the only superpower. This again is supposition on my part, but is, I think, pretty obvious. And if they want to supplant the U.S. as the only global superpower, than inflicting economic damage on your principal geopolitical competitors is not a bad long-term strategy, even if it costs you something in lost trade along the way. It reduces the amount of money your competitor has for military and diplomatic strength. It focuses their attention on domestic issues. And it creates friction between domestic political parties. All of these are helpful to a China that is eyeing the top spot, and would prefer to get there without military conflict.

Beyond 2010

If we assume, once again, that none of the terrible “what-if” scenarios happen, then what happens after 2010?

America’s economy will continue to recover, but more slowly than desirable, and more slowly than in earlier recessions. This was not a typical recession, but was precipitated by too much debt accumulated by consumers, state governments, and, ultimately, the U.S. federal government. It takes time to pay off debts and recover spending power after the excesses of the last 25 years, which is why this recovery will be so anemic. Moreover, with so much of the U.S. housing market still under water, with mortgages bigger than current property values, it will take a long time for home owners and mortgage lenders alike to recover from the scars. This means that 2011 and 2012 are likely to continue to be less than robust.

Beyond 2012, I expect that the U.S. economy, pulled along by the global economy, the Rapidly Developing Economies, and American ingenuity and grit, will begin to pick up speed. And unless some additional shocks or surprises occur, I would expect the economy to continue to grow, and prosperity to return, through the balance of the 2010′s. It will also be accompanied by persistent high inflation – perhaps not high by 1970s standards, but higher than we’ve been used to in the past 20 years or more. This may make it tempting, beyond 2012, for central banks, lead by the U.S. Federal Reserve Bank, to put on the brakes, raising interest rates significantly in order to slow inflation. However, higher interest rates will actually have relatively little effect, because this bout of inflation will be driven primarily by bottlenecks and shortages, particularly in oil production and food, as mentioned earlier. This is going to pose a real quandary for central banks: How can they temper inflation when it’s mostly caused by too little supply rather than by too much money? The only way to lower inflation in that kind of environment is to lower economic growth – and that won’t be very appealing to any central government after years of soft growth.

All told, then, this is going to be a fragile decade for America and her mature trading partners, and the potential for bad things to happen will remain high for quite some time.

RDC’s – The RDCs will continue to grow rapidly, boosting each other’s growth, and gradually pulling the rest of the global economy with them. They will be the principal drivers of the global economy this time around, not the U.S. The bigger question, and one worth watching carefully, is whether their consumers begin to increase their consumption, taking the place of consumption-happy Americans. And how the RDCs deal with the challenges of rising, and persistent, inflation will also tell a great deal about how mature their governments and central banks are.

Canada – Canada’s economy will continue to be uneven, with Ontario and Quebec lagging behind, and the resource economies moving forward with the prices of their resources. However, both Ontario and Quebec are committing significant resources to capture some of the new industrial strength of the green economy. This, along with the slowly improving automotive market, will gradually allow Central Canada to begin strengthening with the advent of the ‘teens of this decade. Meanwhile, low interest rates, kept in place to stimulate economic growth, may produce a bubble in real estate prices in Canada, especially in the major cities, that may threaten Canada’s stability. It would be ironic, indeed, if Canada dodged the bullet that knocked off the American economy in the financial crisis of 2008, only to get hit by it in the next economic cycle. And yet, that is, implicitly, what Mark Carney, the Governor of the Bank of Canada, has been warning for some time. As well, the leading edge of Canada’s baby boom will be entering their 70s by 2020, and that will lead to lower economic growth, and shortages of skilled labor in many areas of the economy. The next 10 years will be a decade of real potential combined with real challenges for Canada.

Europe – In theory, Europe should be the strongest region of economic growth in the developed world. Yet, it is going to struggle at least as much as America, if for different reasons. Britain’s housing market and mortgage market went through pretty much the same wringer as America, and it’s government ran persistent deficits through the fat years that leave it without much ammunition to face the challenges ahead. China has instituted what amounts to a competitive devaluation by pegging its currency to the U.S. dollar, which has been persistently weak compared to the Euro, and will make it harder for Europe to compete with China in world markets. But the clincher really is that Europe is old, and the labor forces of its member countries offer either no-growth or are shrinking. Since, simplistically, GDP growth is composed of labor force growth plus productivity growth, this means the either Europe must massively improve its productivity, or it is going to see its economic growth stagnate, and its share of global output shrink throughout the next 10 years.

Let me start by defining risk management as the process of asking the right questions about what might happen in the future, and then preparing the best plans you can to deal with events that might occur. Hence, if there’s a major pandemic, and if you’ve considered that possibility, have a plan prepared to deal with it, and the plan works reasonably well, then you have adequately managed that risk.

And yet, I very much doubt that any contingency plan, no matter how well you prepare it, will deal with everything that happens – you will still be caught by surprise in some regards. This is why you always need to do a “lessons learned” assessment after each crisis. Your task in risk management, though, is to both to be able to cope with problems as they arise, and to be prepared to change your plans when new, unexpected developments occur.

I’m going to approach risk management from a futurist’s viewpoint, not from the body of risk management literature, so my view will be different from the risk management texts that are out there.

And let me start by making three comments about risk management. First, the best kind of risk management is where you forestall problems rather than cure them. Hence, successfully promoting the use of condoms for safe sex is better than being prepared for a widespread outbreak of AIDS. Second, risk management can’t always allow you to stop problems from happening. You can’t stop a plane crash, because that’s out of your control, so the appropriate response then becomes containing the problems, keeping difficulties to a minimum, and producing the best possible corporate outcome in the most cost-effective manner. Hence, while you may not be able to stop a plane crash, you can make sure that you don’t allow too many key corporate leaders to fly in the same plane. And third, not all risks are negative. This last point is often not considered at all, or is considered to be outside the purview of risk managers, but I contend it is critically important to proper risk management.

Suppose, for instance, in-house research allows you to cut carbon emissions, reduce costs, and improve customer satisfaction (which, by the way, is not that far-fetched as it might sounds as it has been the focus of work I’ve done for number of clients). Or consider a significant increase in productivity, due to new technological tools. Does your organization have the awareness and ability to capture the benefits of such improvements, or will you waste the opportunity? I know that, for many groups, this has more to do with the responsibilities of senior management; my point is that not all the changes we face in future are negative, and managing positive outcomes can be just as important as managing negative ones – they just don’t get as much attention. I call this the “lottery effect”; if improperly managed, positive outcomes can be frittered away, as often happens when someone wins a lottery and blows all the money.

Three fundamental types of risk

Next, I believe there are three fundamental kinds of risks to be concerned about: Rapid onset, gradually developing, and unexpected.

Typically with rapid onset risk, you will have considered a catastrophic event, but when it happens, it’s still a shock because of the speed with which it occurs. Examples include SARS, a flu pandemic, a plane crash with senior management on board, or a major product defect that causes harm to customers or clients.

With a gradually developing risk, you can see it coming, but because it happens over a long period, no one day seems that urgent and you can usually justify deferring action. Examples include the rising level of financial stress due to an aging population, and the growing abuse of mortgage financing in the States from 2000 and before. Eventually such gradually developing situations reach a tipping point where they become a crisis. At that point, if you haven’t prepared for it, you can look awfully foolish. After all, after the fact, everyone saw it coming, so why didn’t you? This is precisely what happened with the financial panic of 2008.

Finally, let’s consider the unexpected. The unexpected risk is something that happens that you haven’t foreseen or considered, and to which you must respond. Among the more recent classic examples are the terrorist attacks of 9/11, the south-Asian tsunami of 2003, or a tornado hitting downtown Chicago.

The classic responses to these three kinds of risk also tend to vary, according to the type. The classic response to rapid onset risk is to deploy the contingency plans you’ve prepared, if they exist; otherwise people will treat it as they will an unexpected risk. With a gradually developing risk, the classic response is to ignore it, and hope for the best. With an unexpected risk, the classic response is panic.

You need to think through all three kinds of risk, and have plans to deal with them. Most of the effort devoted to risk management is spent on the first category, rapid onset risk, but you can be devastated by all three. It can be argued that the second category, gradually developing risk, actually falls more into the area of corporate management rather than risk management. That may or may not be appropriate, but however you define it, you still need to manage it. And, of course, managing the unexpected is, by definition, hard to do, but you can try to whittle down the types of things that are unexpected. I’ll return to this later.

Environmental scanning

Next, I’m going to discuss risk management in two parts. First, I’m going to survey the future, which is also called “environmental scanning,” and talk about some of the risks I see ahead of us at this time. Then, I’m going to talk about a particular approach to risk management. I’m also going to give you some tools to take home and use, and discuss how you can use these tools to improve your strategic foresight and develop appropriate contingency plans to cope with all three kinds of risk. So let’s start by talking about what risks are out there that we can see

Let’s start big, first with global health, and then the global economy.

We know we are experiencing a flu pandemic, but what we don’t know is how bad it will be. Although there have been deaths from the H1N1 strain, the number of deaths in the Southern Hemisphere was significantly lower than for the normally expected seasonal flues of recent years. However, this was also the pattern we experienced with the Spanish flu of 1918-20, so let’s review that pandemic. We don’t really know how bad it was, because there weren’t as accurate global statistics as there are today. However, the estimates I’ve read indicate that roughly one-third of the world’s population, or about 500 million people, caught Spanish flu, and between 10 and 20% of that third died from it. This death rate is between about 3 and 6 times normal, and would overwhelm our health care system.

Now transpose these sickness and death rates to your own staffs. Imagine having 12% of your staff sick at any one time, and having 5-10% of your staff die from a pandemic. What would that do to your company’s ability to operate? Probably decimate it, regardless of any contingency plans you’ve made – but the real issue becomes how badly you are affected, and how quickly and well you recover.

Of course, global pandemic plans aim to break the cycle of infection and transmission, so it’s quite possible that isolation and inoculation could keep these numbers down. But in your plans, this is the kind of rapid onset risk you need to be considering. So far, this kind of killer flu pandemic has been a once-a-century risk – but we’re due, and there is, now, a potentially nasty pandemic that we know is happening.

By comparison, there’s another pandemic that is also happening, but as a gradual onset risk, which is why you haven’t heard much about it. The rise of antibiotic-resistant bacteria represents a very real threat to public health, but its rise has been relatively slow and steady, so we’ve tended to ignore it. We know it’s happening, but there isn’t the same kind of outcry about it – it doesn’t get the media or political attention, even though it may ultimately claim more lives than the H1N1 flu.

Now let’s step back and consider a more complex probable risk. Suppose we get hit by a combination of events, such as the emergence of a hyperbug – resistant to all known antibiotics – while we are fighting the flu pandemic. This is not an improbable scenario: if health professionals are overworked and tired, or overwhelmed with patients even after triage, as might well happen in a flu pandemic, then they may get sloppy with protection procedures. Then, add to this the inevitable overcrowding of hospital facilities and there is a real increase in the probability of the emergence of a hyperbug, leading to substantially higher death rates, and a dramatic decrease in the effectiveness of health care facilities and practitioners. Have you thought about or planned for these kinds of combined risks?

The potential for nasty economic surprises

Now let’s turn to the economy. At this stage of the cycle, when the economy is starting to grow again, it’s easy to assume that things will continue to get better. That’s probably the case, but the economy and the global financial systems are still fragile, so we could be shocked by new nasty surprises that still might happen. I’d like to mention three possibilities, although there are others.

The first is that the American banks – and others – are now starting to register significant losses on commercial real estate loans. If things go badly, this could push more banks into insolvency, trigger a new run on banks, reigniting a financial crisis. These aren’t the same big, money-center banks, by and large, but a lack of confidence in some banks could easily spread throughout the system, as we saw last October.

The second is one we’ve all rather conveniently forgotten: toxic debt. It was lack of due diligence on the part of all the financial players in the States – and elsewhere – that led to the creation of all of the toxic, asset-backed securities in the first place, and there are trillions of dollars of this stuff still out there. At some point, someone has to figure out how to value these securities – which may be impossible – or write them off entirely. However they are dealt with, someone is going to have to take big losses – and taxpayers are almost certain to figure prominently in this group.

And the third, and potentially most dangerous, is a wild card: the possible insolvency of the government of the United States. Let me cover this with a quote from the blog I posted on my website in June, 2009, “Is America Too Big to Fail?”:

“… the U.S. federal government, unless it makes a Herculean effort to change direction, will fail. … With the U.S. already the biggest debtor nation in the world, with its biggest [external] creditor, China, already musing publicly about whether the U.S. government is capable of supporting the debt loads projected, and with market players musing about whether the U.S. government will lose its AAA credit rating, who is going to want to step up and buy more U.S. securities than have ever been sold before? Why would any sane investor want to take that kind of risk? … If the American government tries to sell all of this new debt, and doesn’t find enough takers, than the U.S. government won’t have enough money to pay the bills it is so freely running up. Its checks (or cheques) will start to bounce; it will be functionally bankrupt.”

Am I sure that these things will happen? No, and I clearly hope they don’t. But the difference between a crisis and an opportunity is foresight, and foresight implies taking a hard look at reality, whether you like it or not. And just as clearly, you need to have a Plan B ready to deal with these kinds of possible shocks. I would classify a possible default by the government of the United States as a gradual onset risk – and, as such, one that we all tend to ignore.

The aging of the population: another gradually developing risk

Now let’s turn to one aspect of demographics that is clearly defined and falls into the gradual onset category of risk: the aging of the population. Average per-capita health care costs tend to remain reasonably stable from about age 2 until around age 55 – but then they start rising almost exponentially. The baby boom – the biggest generation in history – is entering the high-rent district of health care. They were born between 1947 and 1967, so the leading edge is turning 62 this year. This is inevitably going to push up spending on health care, as will happen not only in America and Canada, but throughout the developed world.

Three things will happen as a result: First, program spending in every other area will have to be cut to allow for greater health care spending – which will make for uncomfortable choices, acrimonious cabinet meetings, and unhappy users of government services. Next, governments and corporate payers will try to cut back on the things that government- and corporate-sponsored health insurance covers (you can already see this happening), with the result that there will be pressure from unhappy voters to spend even more on health insurance. And finally, there is a high probability, in my view, that taxes will rise, and might rise significantly.

This is clearly an example of a gradual onset risk – and yet, it’s one that governments and the private sector alike are ignoring, but which will have significant, even dire, consequences. There is a very real risk that these problems could bankrupt not only American and Canadian national, state, and provincial governments, but the governments of developing (and rapidly aging) countries around the world as well. I’ll bet that very few organizations here have even considered this in their risk management planning

Unexpected risks

Now we come to unexpected risks.

There are positive risks ahead of us that are highly probable, but hard to anticipate. There are going to be immense new opportunities opening up to do things that have never been done before – but they are difficult to forecast precisely because we have no experience with them. For example, I worked on one of the first applications for cellphone licences in the early 1980s. Our group (which did not get a license) did a feasibility study of the potential demand for cellphones, and concluded that it had money-making potential because almost 8% of consumers said they were likely to use a cellphone. This was good enough to establish a business case, but our projections were wrong by almost a factor of 10. Neither we, nor anyone else, expected the extent of the market penetration of cellphones at a time when they cost over $2,000 each, and were so heavy that you had to store them in the trunk of your car. The reality turned out to be much better than we had projected – and could have bankrupted us if we had won the license, but had not had the necessary working capital to fill demand.

Next, have you considered the risk to your business of someone you don’t know applying technology in novel ways? Let me use as an example a prognostic test for cancer, for instance, that is about to be submitted to the Food & Drug Administration for approval. (And pause for disclosure: I’ve worked with this company, and hold shares in it, but it’s not publicly traded, so you couldn’t buy shares in it anyway.) This test has been produced by a young upstart of a company that applies patented, problem-solving computer software to come up with tests and treatments for cancer. The test promises to be significantly more effective than current techniques in telling patients who have had surgery for colorectal cancer whether they should have follow-on therapy or not.

Now suppose you were a pharmaceutical company that had just come up with a new drug to treat Stage III colorectal cancer, only to find that this young upstart could tell half of your market that they don’t need any additional cancer treatment, and a third of the remaining market that they can get results that are as good, or better, with a cheap, out-of-patent drug? Tufts University estimates that in 2006 it cost $1.2 billion to develop and market a new drug, and suddenly you find that market for your drug has just been scooped by a company offering two tests that cost about one-tenth of a course of your new drug. Where were the risk managers in your organization while this was happening?

Governance risks

Which leads, rather naturally, into governance, both corporate and public sector. I would suggest that a number of the things I’ve characterized as risk most organizations tend leave to senior management, particularly gradual onset risks, and positive risks. But what about management itself as a risk?

Looking back at last year’s financial collapse, it’s clear that the interests of the organization and the interests of management don’t always coincide. What happened in the U.S. financial system (and elsewhere) was that senior managers were chasing the prospect of enormous bonuses by pushing their organizations into taking unreasonable risks. This is a classic case of “heads I win, tails you lose”, because all that could happen to the executives would be that they were fired, whereas many corporations lost everything, either by being taken over (Bear Sterns, Merrill Lynch) or going to the wall (Lehman Brothers, AIG).

The problem is only partly recognizing these risks; the other part is how do you deal with someone to whom you report who is putting the corporation at risk? Especially if the Board of Directors is involved as well? I would suggest that you’ve already lost if you encounter a situation where you are trying to change the behavior of senior management that is pursuing personal gain at corporate expense. Instead, this is the kind of risk that, probably, can only be dealt with by anticipating it. In particular, you should seek to have corporate policies in place that identify such behavior, and provide an accepted means of blowing the whistle if it happens. Even then it’s dicey – which only heightens its importance.

Next let’s consider external governance risks. We’ve already talked about two potential government risks: rising taxes because of health care costs; and over-reaction because of privacy violations. I think you should also consider what happens when governments are faced with a world where they have less and less influence at a time when their constituents are feeling more and more anxious. You are likely to get governments that act irrationally, and look for scapegoats and whipping boys. And if your company happens to be handy for that purpose, it may be your turn in the barrel. I would strongly suggest that one of the risks you should consider preparing for is arbitrary government actions. You should watch for it, and have contingency plans in place for dealing with it. And remember; it’s easier to head off such developments than to undo them once they’ve become law. This also argues strongly for working together as a group, both here, and within your own industries, because an industry has more chance of influencing outcomes than a single company.

The balance of this article, dealing with techniques for risk management, will appear next week.

Well, first of all, the developing countries had a really rough first half – but mostly that was due to what has classically been described as inventory overhang, about which more in a moment. They had been doing so much business with the developed countries, especially America, that they had a whole raft of product in the pipeline when the U.S. economy hit the skids. Now they’ve liquidated that inventory by cutting production, which slashed growth rates in the first half, and are now back to filling current demand. As a result, they’ve taken a hit, but are bouncing back.

Next, the developing countries, especially in Asia, have stimulated their economies, and are seeing the response. Their investment in infrastructure, both at the governmental level, and plant and equipment for corporations, is strong, and consumers have responded to stimulus with demand, just as it says in the textbooks. But in addition to that, the developing countries are trading more and more with each other, and, consequently, are not as reliant on demand from America, Europe, and the other OECD nations as they were before. Hence, as the fast growing countries start picking up steam, they help each other grow even faster, even without their biggest customers. For example, Brazil now buys more from China than it does from America, it’s traditional major supplier, with the result that as Brazil rebounds, it helps China, and vice-versa.

Meanwhile, things don’t look as bad as they did back home. The governor of Canada’s central bank, The Bank of Canada, has declared the recession in Canada is over. The U.S. Federal Reserve has said that the bad news isn’t as bad any more and we are probably at or near the bottom of the recession. France and Germany are starting to look better as time goes on, and will see positive growth this quarter. But it’s not going to be a quick rebound, because this is not a typical recession.

Not your traditional recession

A traditional, inventory-liquidation recession happens when the economy has been booming along, and everyone’s making easy money. As a result, organizations try to sell as much as they can, filling their pipeline with products to be sold, and operating at or near capacity. In the process, they take on short-term debt, typically bank debt, to finance their operations and inventory. As a result, when something happens to slightly jiggle the apple cart, or when the interest paid to the bank to finance inventory start to hurt more than the potential profit warrants, corporations decide to try to lighten up a bit by cutting back on new purchases and production. When everyone tries to do this at the same time, demand nosedives, and the economy goes into the tank. When the inventory has been cleared, the bank debt has been paid off, and the smoke clears, a few companies go broke, but the economy as a whole resets, and starts growing again in a new cycle, typically with strong growth for the first couple of years following the recession. This kind of traditional recession & clearing process took anywhere from 6 months to 2 years.

This is not that recession, not in America. This recession was triggered principally by consumers having too much debt through 25 years of using their home mortgages as an ATM. That kind of long-term debt takes time to pay off, and consumers have to consume less than they make in order to do it. This puts a long-term damper on the economy that takes a long time to wear off.

If we are lucky, America’s economy will be almost flat for the balance of this year, but start growing – slowly – next year. By 2011, it will start to pick up, but growth will still be anemic, and people will be complaining that the recession hasn’t ended. In fact, we are likely to see an unusual combination of rising economic output AND rising unemployment for an uncomfortably long time, perhaps even into 2012.

Possible shocks to be wary of

If we’re not lucky, then the American consumer, having been shocked into a penitent, saving mode, will stay in his or her shell and refuse to buy anything, or will only buy what they have to, for a long time. Add to this the potential for further financial market shocks, which I’ll describe in a moment, and you have a very gloomy scenario indeed. Moreover, if growth stays weak, and unemployment stays high, President Obama may wind up losing the White House in 2012, despite the structural weaknesses of the Republican party, because the economy is the single most consistent indicator of electoral success.

Now, what might be the possible further shocks? Well, if economic growth stays weak, the U.S. government will want to continue to stimulate demand, which means running deeper budget deficits for longer than currently planned. And as I’ve said before (“Wild Card Warning”) the U.S. government is already at risk of running out of money because of the enormous amount of debt it must raise on the open market. If lenders grow weary or leary of U.S. debt, then the U.S. government faces a credit crunch of its own that could precipitate a new financial crisis, and tip the global economy into a renewed depression. Or, if that can be avoided, the banking system is not yet out of the woods, because loans they made for commercial properties are turning bad, and may put further holes in bank balance sheets, again precipitating a new crisis. Neither of these are inevitable, but are real dangers that should be watched carefully, and for which contingency plans should be formulated now.

Canada’s dilemma

In contrast, Canada will experience an interesting dilemma: the demand for oil and food is already growing again, in large part because of the developing countries, and Canada is a major producer of both. (Most people are not aware that Canada has the second largest petroleum reserves in the world, after Saudi Arabia, and is America’s biggest supplier of oil. It’s very expensive tar sands oil, but it is flowing, and makes Canada a petro-power.) As a result, on average the Canadian economy will do pretty well among OECD nations – but this average is deceptive. Demand for Canadian commodities will and is already pushing up the Canadian dollar. This will further damage the country’s industrial heartland in Ontario and Quebec, which are already being hollowed out by the woes of the auto industry, and the transfer of manufacturing to lower cost producers like China. Meanwhile, the parts of Canada that produce commodities, notably Alberta and Saskatchewan, will be feeling no pain. This will exacerbate the real political stresses within the country, where almost two-thirds of the voters come from Ontario and Quebec, but virtually all of the strength in tax revenues, and the large majority of the economic growth, is coming from the western part of the country. It creates an almost impossible situation for the national government, quite aside from the current government’s short-comings and evident weaknesses.

Looking farther out into the future, unless the nasty contingencies described earlier occur, growth and prosperity will return to the “rich” countries, although slowly, and this time people will be more cautious. Some of the thrifty virtues our parents preached will once again be rediscovered, and time will heal the wounds, investment will once again accelerate growth, and (more measured) good times will roll again. This pain, too, shall pass.

Destruction carries the seeds of recovery

In its wake, it will leave the developing countries stronger, the developed countries growing again, but more cautious, and a more interconnected and interdependent world. If we have learned nothing else, we have learned that in today’s world, no one crashes on their own. This cautionary tale may well pave the way to a more stable world economy, and one where fair trade for all is seen as the only alternative to disaster.

Every boom carries the seeds of its own demise. Likewise, every crash sows the seeds of new growth, and new innovation, just as many forests require forest fires to renew themselves. This time will be no different. Carrying the metaphor forward, we’re not out of the woods yet, but that glow on the horizon is more likely to be the dawn than a renewed conflagration. Hold on to that.

“What if I’m wrong? What else might happen instead?” This (two-part) question may just be the smartest question in the world, because it allows you to lift your head and look around at a broader world, outside the boundaries of your opinions and preconceptions. If you’re considering the future, as I do, then this is a critical question that can save your, uh, face repeatedly, and the current financial-crisis-and-recession environment is a perfect example.

This has been, and continues to be, an economic period for which there are no good precedents, and the only ones that come close, like the Great Depression of the 1930s, are unnerving, so that people don’t want to contemplate them. And there are so many things that can happen to change the course of events that trying to predict the One Right Thing That Will Happen is effectively impossible. But you still need to decide what to do, and that’s where this question becomes so valuable.

Strong Opinions, Weakly Held

So the first step is to come to a decision about what you think is going to happen. Someone once defined the job of a futurist as having strong opinions, weakly held. This means that, first, you have to have an opinion, but then, you have to be willing to change your mind when the facts indicate that you’re wrong. This goes against what most people do: they have weak opinions, strongly held, by which I mean that they usually don’t have strong opinions, but once they voice a thought, they will defend it to the death rather than admit they made a mistake, even in the face of clear evidence that they are wrong. This is exceptionally dangerous, especially in a world that changes as quickly as ours does.

In this case, I believe the current recession in America will continue throughout 2009, but with the signs and portents getting better and better as the year goes on. I expect the recession will end in early 2010, possibly as late as the 2nd quarter, but I doubt it will take that long. I also believe that growth will be so slow that unemployment will continue to expand, so that GDP and unemployment will both rise at the same time, which is both distressing and unusual. Moreover, I believe that people will continue to feel challenged by the economy through all of 2010 and into 2011. Towards the end of 2011, I expect things to be getting better, and people to be feeling more positive – and that’s the point where people will begin to believe the recession is over, even though it ended in 2009.

Meanwhile, the Rapidly Developing Countries (“RDCs”), notably China, India, and Brazil, will be growing more strongly, and recovering from their growth slow-downs more quickly. Their growth will put upward pressure on commodity prices, especially oil, faster than we would normally expect, so that inflation will re-emerge, particularly in energy prices and food, in 2010. If central banks don’t start to mop up all the excess liquidity in the global financial system at about that time, inflation could become a serious issue in 2011 and the years that follow.

Other Possible Futures

That’s what I think is most likely to happen. But what if I’m wrong? What might happen instead? Well, there are a number of alternative possibilities, also called scenarios, but let me focus on two in particular. The first is that there is another financial crisis. This could happen if a major, non-financial company runs out of cash, and slips into bankruptcy unexpectedly. They might be profitable, have significant assets and book value, but just run out of cash, and are unable to borrow working capital from the still shell-shocked banks. If that were to happen, it would panic the financial markets, because here is a solid, apparently stable company catching everyone off-guard with an unexpected bankruptcy. Or the banking system could go into another tailspin as loan losses, this time from commercial real estate, start hitting their balance sheets, triggering another round of unexpected bank runs. This, too, would trigger another panic. Or deflation, which is a vicious downward cycle of prices caused by weak economic demand, leading to weak prices, leading to weak profits, lead to weak demand, and so on. Any of these things could trigger another panic, and kill off any nascent economic recovery, producing a persistent recession or depression, which might last for years.

But I could also be unduly pessimistic about the economy. It might come back more rapidly than I expect, with scavengers swooping in to buy distressed houses at bargain prices, leading to a literal land rush in real estate, repairing bank balance sheets, and encouraging consumers. A stronger stock market, with rebounding values, would add fuel to the fire, and further increase confidence, leading consumers to start buying – cautiously and judiciously at first, then with greater strength and vigor. This could lead to an earlier recovery, stronger tax revenues, and a rapid rebound in government finances, especially at the state and local levels. In turn, stronger demand in the developed world would lead to a more rapid turnaround in the RDC economies, and trigger a faster rise in inflation, with oil pushing through $80 in 2010, and pointing much higher later. Indeed, if things get too strong, too quickly, we could see inflation return to levels unseen since the 1970s, and central banks being slow off the mark for fear of bringing the recovery to a screeching halt. This could lead to a new asset bubble, this time in commodities, with oil and food leading the way.

The Payoff

But however you see the future unfolding, the whole point in asking “What if I’m wrong?” is to give yourself greater breadth of vision, and allow yourself to make and, as appropriate, develop and use contingency plans to deal with alternative futures. There’s a structured way of doing this, called scenario planning – but that’s another rap for another time.

Oh, and one more advantage to asking “What if I’m wrong?”: it keeps you humble, and makes it easier to see the world as it really is, not as you expect it to be. And that may be the most valuable benefit of all.

Please feel free to pass this blog along to others you think might find it of value.

Best regards,
Richard Worzel