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The next bubble: Follow the line of debt to spot a coming crisis

"You might take a long-term view that unless something goes fundamentally wrong it should still be a good growth story, albeit not quite as good as in the recent past, for the next 20 years."


Richard Milne
Financial Times
22 March 2011

Mark Thomas, a business strategy specialist at PA Consulting, has a single sheet of paper he shows to clients that could strike fear into any chief executive, investor or regulator.

It shows a radar screen with the dozen or so events he thinks could over the next decade potentially be the next landmine for the global economy.

Broken into four areas representing risks in the consumer, corporate, banking or government sector, the chart shows worries stretching from a commodity price shock to the health of financial institutions in the eurozone and China.

But many of the biggest "bubbles" on the radar screen are located in the government sector.

Few countries are spared from being a potential problem: alongside the usual suspects of the peripheral eurozone countries of Greece, Ireland, Portugal, Spain and Italy, Mr Thomas has placed Japan, the US, the UK and even China.

"There has been a huge transfer on to government balance sheets because of the crisis," he says.

As regulators and companies peer on to their own personal radar screens to see what the next bubble might be, the options can seem bewildering.

Even when it can be identified, working out when it will pop is almost impossible. The previous bubble was no different. While several economists warned of the dangers of subprime lending in the US or property prices in Spain, many of them did so for years before the event.

Only four years after the financial crisis first broke, the danger of complacency is already back.

Analysts at Citi noted in early March how deep out-of-the-money equity options – which would make large amounts of money only if stock markets fell precipitously – were at their cheapest since before the collapse of Lehman Brothers in 2008. Steven Englander, a currency strategist, noted signs of "Black Swan fatigue" – weariness with the idea that an extremely unlikely event could take place and cause havoc in the markets.

Difficult as it is to spot the next bubble, some strategists and investors say the answer should be relatively simple: follow the debt.

"It is very easy to tell where the next bubble is forming: it is whichever sector is taking on the most debt. You can get bubbles that are not associated with debt, but nobody really worries when they burst," says Matt King, head of credit research at Citi.

Under his analysis, debt helps explain why Japan went pop in the 1980s, companies at the end of the 1990s, and banks in the past decade.

Now the debt – as demonstrated by the eurozone crisis – is all at the government level.

For some analysts, this represents potentially the final act in a decade-long drama that has seen companies, consumers and banks all have debt problems.

"If you think all the bubbles of the past 10-15 years were connected, then government bonds are the last shoe to drop," says Jim Reid, credit strategist at Deutsche Bank. "Governments are the last chain in the rolling supercycle of bubbles."

The peripheral eurozone countries look most immediately challenged, and their problems also fuel concerns about banks in France and Germany.

But as Mr Thomas’ radar screen demonstrates, few countries can be excluded.

Some investors argue that Japan, the UK and the US should be excluded as they can start the printing presses, but the potential for intense concerns about the level of their debt in the coming years remains. "It is all a big confidence trick. It has worked in the US so far. But the debt is still there and that leverage creates much more downside risk and fragility than people think," says Mr King.

Mr Thomas even believes China could be at risk, joining some hedge fund managers in fretting about the fast-growing economy. His argument is that investment in infrastructure is such a big part of growth rates that, coupled with the difficulty in trusting economic data and a belief that it is a new era for China, makes a bubble a possibility.

So what should people do about potential bubbles? Ignore them or worry so much they do nothing?

Mr Thomas argues the first thing is simply to acknowledge they exist.

"Don’t run your business on the basis that everything will be perfect. Some landmines will explode," he says.

But just because a bubble might be brewing in, say, China, it does not mean investors should shun the country.

He adds: "If China is a bubble you don’t want to invest in Chinese real estate. But you might take a long-term view that unless something goes fundamentally wrong it should still be a good growth story, albeit not quite as good as in the recent past, for the next 20 years."

To read the article online, please click here.

To read about PA's expertise on strategy consulting, please click here.

To read a previous article where Mark has been quoted, please click here.

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