In the initial module of Growing Foxes, we introduce students to the art of identifying drivers/flags which can turn the world around them upside down. Think of the first domino as the driver or flag. If it is toppled, all the other dominoes in the row topple too.
We not only want our students to improve their ability in scanning the horizon for the equivalent of the first domino to fall; we also want them to trace the causal chain linking it to the other dominoes before they fall too. That demands foresight to play the relevant scenario in advance and the imagination to work out the best strategy to handle the potential challenges posed by the new narrative. Then, like the scouts, they are prepared for the best and the worst.
Let me give an example before getting on to the real purpose of the article. In April 2006, I was asked to go to the Central Party School just outside Beijing. It is the inner sanctum of the Chinese Communist Party, developing its future leaders and formulating the five year economic plans which drive the nation forward. They wanted to understand how the methodology of scenario planning could be used to road-test their five year plans.
So I asked them what their real fear was at the time. It was an American financial crash because China already held in excess of one trillion dollars of US treasury bonds. We played the scenario of a US crash and what they would do internally to compensate for the loss of exports to America. But then I asked them what flag would indicate the scenario was about to materialise. They went into a huddle and came up with a fall in property prices in America.
Their reasoning was that the principal asset of an American consumer is his or her house. If it fell in price, this would depress consumer spending in America which represented two-thirds of its GDP. That would trigger a recession which would then put pressure on mortgage markets as borrowers would have less income to service their loans. The difficulties faced by the mortgage providers would flow over into the banking industry with the stock market being the final domino to fall.
Even though the actual cause of the 2007/8 crash was sub-prime mortgages and the failure of the rating agencies to recognise them as such, the flag chosen by the faculty turned out to be brilliant. In the last quarter of 2006, US property prices levelled out after having risen for 20 years, and in the first quarter of 2007 they started to come down.
The probability attached to the crash scenario by the faculty therefore leapt in early 2007 because in their eyes the first domino had fallen. Yet the American stock market only turned down in September, 2007. In other words, by selecting that flag, China’s principal economic strategists were ahead of all the so-called wizards of Wall Street in anticipating the crash.
I have related this story in detail because a second crash may be on the cards for different reasons. The scenario is entitled 'Forked Lightning' as lightning usually strikes more than once. The flag in this case is the rise in global oil prices since the middle of 2017. Brent Crude sits at $82 a barrel now compared to $47 then. That amounts to a 74% increase. Moreover, if the disruption caused by Donald Trump withdrawing America from the Iran deal has even more serious repercussions for the oil market, we could see the oil price over $100 again.
All of this may constitute the first domino to fall in a lethal chain. The logic is that America and Europe have lived in a world of virtually zero interest rates set by their central banks since the crash of 2007/8. This has been possible because annual inflation rates have remained remarkably low too. While a policy of plentiful cheap money was supposed to restore long-term economic growth rates to the level achieved in the last century, this has not yet happened. Meanwhile, debt held by governments, companies and individual households has boomed to a colossal amount in excess of the figures preceding the last crash.
Given the last statistic, the surge in the oil price could upset the apple-cart, along with the fact that the US unemployment rate is at its lowest in many years. The latter could signal a significant rise in real wages following a lengthy period where they have remained almost flat.
If these two dominoes cause the inflation rate to rise faster than expected, central banks will be forced to put up interest rates quicker than planned. The cost of all variable-rate loans taken out in the good years of minimal interest rates will overnight become much more expensive to service. New loans will cost more too. The risk of defaults will therefore jump and so will the chances of another crash. Indeed, some countries with high national debt-to-GDP ratios may go bankrupt.
Right now we have upped the probability of Forked Lightning, or a repeat of 2007/8, from 10% to 20%. It is still an outside chance but the flags in the chain outlined in this article must be put on a constant watch list. These include the oil price, the inflation rate in America and the 10-year US government bond rate.
It is also worth remembering that a diversified savings portfolio is what helped most people survive the last crash and the same will apply if and when the next one happens. Be prepared.