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Where Are the Land Mines Hidden?
By: Dr. Charles Lieberman
Date: 6/1/2009
GM's landmark bankruptcy has been expected for some time, so it should set off hardly a ripple, especially when compared to Lehman's failure. Loan losses at the major banks are now old news. Besides, the government has already injected billions into the weaker firms and forced all the largest ones, as well as many sizeable ones, to raise capital or merge. When scouring the landscape to identify potential surprises, it seems like some of the worst potential problems have been addressed. Still, there's always room for a surprise or two. The economic recovery might prove to be weaker than expected, although it seems like expectations are set quite low. Perhaps the surprise is that the economy might rebound at a solid pace. Perhaps we're headed for a quiet boring summer. That would be a nice change.
Looking for surprises is a difficult exercise, since surprises are hard to anticipate. Still, it is useful, as we consider our vulnerability to unexpected economic and political developments. North Korea is a political nightmare, but unlikely to disrupt the economy or the markets. The same can be said about the Middle East, barring an assassination that disrupts oil supplies. Putin could engage in some mischief, but that appears more of a problem for Europe, if he disrupts gas supplies.
Domestically, our greatest uncertainties surround the outlook for the economy, although a weak recovery is widely expected, so it would be more of a surprise if the economy rebounded strongly. Much of the work left for policymakers is to continue shoring up banks, helping credit markets to continue improving, while promoting recovery. But these are processes that take time. They don't lend themselves to sharp surprises. As the credit markets recover, even junk-rated companies are actively engaged in refinancing themselves, reducing the risk of a shocking failure. And after the problems at Citi, G.M., and Lehman, it is tough coming up with a new significant candidate capable of a major adverse surprise.
Risk measures have been falling. The VIX has reverted to levels below 30, suggesting investors expect reduced volatility. Treasury yields are rising, even as junk bond yields are falling, implying that investors are now taking on some risk, once again. An unfolding economic recovery, even if it takes place slowly, would provide a nice foundation for a more gradual recovery in equity prices. Getting back to normal would be a welcome relief after the turmoil of the past two years, especially if stock prices slowly work their way higher.
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