Economic Woes: What Scares Wall Street

• Governments around the world succumb to political pressure to protect their workers, tanking the global economy.

Levkovich

Tobias Levkovich, chief U.S. equity strategist for Citigroup: “One nightmare scenario that I would focus on is a significant bout of protectionism. With political pressures growing in democratic states — unemployment is 20 percent in places like Spain, not just 9.6 percent [as in the United States] — I could see politicians pointing fingers away from themselves by saying, ‘To fix our employment woes, we’ll make sure we produce goods here and not by people who produce under-priced goods somewhere else.’

“The world has benefited from globalization. It has given us cheaper goods to buy so, net-net, it’s good — unless you’re the one who suffers [a job loss]. Protectionism can cause inflation, a drop-off in business activity, you lose productivity. And it doesn’t have to start in the U.S. It can start somewhere else. I can see this thing unraveling. So far the U.S. administration has been extremely responsible, but you’re asking for nightmare scenarios. This one has a specter of realism to it.”

2. Out-of-Control Inflation

• Trying to stimulate the economy, the Fed creates an inflation monster it can’t control.

Atteberry

Thomas Atteberry, a partner at First Pacific Advisors: “This is one of those frightening ones – the Fed does QE2 [the Federal Reserve program to stimulate economic growth by buying massive amounts of Treasury bonds], pumps lots of money into the system to take inflation from 1.5 percent to 2.5 percent, and it ends up unleashing something that it can’t control. You have central bankers who start tweaking the economy and then they can’t stop it. What if that runs rapidly into an inflationary spiral instead of deflation and they lose control of the currency? Then you can watch the fiat currency system spinning out of control.

“You’re not getting much growth [in such a scenario] because the economy is levered. There’s much more floating-rate debt or short-term debt. You’re crushing the middle class because their borrowing costs are up. You can’t raise rates, the tool to control inflation, because when you do, all of the levered people out there can’t service the debt. A lot of people bought bond mutual funds in the last year and a half. You can’t raise rates on them, either, because you’d crush them. There aren’t a lot of winners in that [QE2] endeavor.”

• As emerging markets get richer and developed countries fall deeper into debt and print money, commodity prices skyrocket.

Sri-Kumar

Komal Sri-Kumar, chief global strategist at TCW Group: “ In the past it was the deficit countries, mostly in emerging markets, that were in difficulty and Western countries would come to their help. The International Monetary Fund and the World Bank were there to provide discipline to emerging markets. The nightmare scenario occurs when we don’t have them to deal with. With the U.S. and Europe having difficulty and China, India and Brazil doing well in financial terms, we don’t have a corrective mechanism. We’re in an uncharted world in terms of how to bring about stabilization. We can’t tell China what to do. No one has ever told a surplus country what to do. You can’t tell a deficit country what to do, either, because they can print more money.

“Brazil and India have a flood of money coming in. They have begun to impose restrictions on capital inflows because the money goes flooding into real estate and stocks. They know from experience that this will always be followed by a crash later on. What you may eventually find is that the U.S. keeps creating money, with foreign countries blocking flows. Where does that cash end up? It boosts prices of commodities and gold. Eventually food costs start to rise and the U.S. and other countries don’t get the benefit they’re looking for. As long as monetary policy is supportive and interest rates stay low, [asset] prices will go up and up and up. Then something comes along to point out that this can’t be sustained and it comes crashing down.”

4. More Bubbles and Busts

• The U.S. prints more greenbacks and global markets gobble them up, fueling a bubble that eventually crashes hard.

Hammond

Brett Hammond, chief investment strategist at TIAA-CREF: “Asset bubbles have been more extreme in the last 10 years than any other time in the last 80 years. We may be in a period where asset bubbles [are more common]. One scenario here is that we step right into a huge bubble that then bursts – I’m not saying it’s going to happen, but it could – but it’s much more fundamental than that. Things have happened in the last decade or two that have brought these conditions about. There’s a huge pool of global capital ready to pounce on the next hot thing; transmission mechanisms – huge global banks and technology – facilitate flows to the hot place; there are new, lightly regulated derivative instruments. If there weren’t this huge pool of capital, QE2 might not lead to a big bubble. You could argue that conditions are there not just for QE2 to do something but for potential bubbles in general to pop up, where true value gets out of whack and momentum takes over. Treasury bonds or emerging markets or some hot sector are things that could be faddish.”

• China exports a new product — inflation — and U.S. workers see prices shoot up while their wages stay flat.

Forester

Tom Forester, manager of the Forester Value Fund: “What if there’s inflation in China? They already have thin margins, so they start raising prices on everything they sell us. Every product that’s made has some input from China nowadays – computers, auto parts, sweaters, iPads, you name it. We see prices going up here and then interest rates get raised and so mortgage rates go up. The nightmare scenario is that your income is flat and inflation starts going up. That’s stagflation. I’m not saying it’s going to happen, but it’s not on anyone’s radar now.” [Editor’s note: Forester’s fund was the only U.S. stock fund to have a positive return in 2008]

• In an uncertain economy, one more scary event could undermine confidence, sparking panic from Wall Street to Main Street.

Buckingham

John Buckingham, chief investment officer at Al Frank Asset Management: “It takes a lot to keep the economy and business down. Despite consumer and investor confidence already standing on shaky ground, the wheels of commerce are still turning and corporate profits are again pushing up against record levels. I suppose that a nightmare scenario would have to do with the mucking up of the business engine. We caught a glimpse of this with the runs on banks and the near-collapse of money-market funds at the height of the financial meltdown. So much is predicated on being able to trust the counterparty in any transaction — financial or business — and an event that would lead to a wholesale loss of that trust would truly be cataclysmic.

“There is obviously a delicate balance. . . . Another flash crash that kills investor psyches or the collapse of a major financial institution like Bank of America would be devastating. No doubt, the loss of animal spirits would reap a huge toll on Main Street, as the unemployment rate would spike, further putting pressure on consumer spending, further hurting businesses, leading to more layoffs. I’d imagine that inflation would become a huge problem as well, as the Fed would have to inject mountains of additional cash.”