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A perfect storm – gearing up to be worse than the 2008 financial crisis – could hit in 2013. That’s the prediction championed by Dr. Nouriel Roubini, the man who predicted the US housing market bubble and subsequent global economic fallout as far back as 2005.

Roubini predicts that 2011 will be a relatively flat year for US equities. The US benchmark index, the S&P500 index, has risen 13% since January this year – so for Roubini to be on the mark, a market pullback from here must happen by year end.

But then, according to Roubini, a significant market correction will hit in 2013. He says that the US Federal Reserve, having spent most of its ammunition in 2011, will have little manpower to do anything about it.

There are other ‘market gurus’ that have 2013 singled out as a bad year. Similarly to Roubini, hedge fund manager Jim Rogers thinks that the next crisis will be worse than 2008 because there comes a point when all the bullets have been shot. Highly indebted nations in Europe, as well as the US, can’t keep piling on more debt.

Marc Faber, the author of the Gloom Boom & Doom report, agrees that 2013 will be a difficult year for stocks as fewer businesses bring in revenue. Faber argues that a slowdown in China and India will amount to another global economic recession.

Predicting the future isn’t an easy task as most economists will readily admit. Back in November 2011, Rogers revealed that he was long the Euro – arguing that the European currency had been beaten down enough. However 2012 has seen the Euro hitting new lows – with little let up in its downward slide.

Rogers also predicted back in mid-2010 that the US would enter recession in 2012. Both predictions have failed to eventuate (although US GDP growth has fallen from 3% to 1.5% over the last three quarters and unemployment has crept from 8.1% to 8.3% since May this year).

Rather than admitting that things panned out differently than originally thought, Rogers has pushed back the start date of these pending disasters ahead. Now, according to Rogers, it’s 2013 that investors should worry about, and 2014 too for that matter. Rogers argues that in 2012 Obama will continue to throw money into the market and the economy because it’s election year. But once that comes to an end, watch out.

Taking on too much debt is like a boat taking on water, and the US economy is sinking fast. As the largest debtor nation in the history of the world, the US can’t keep printing money to keep itself afloat.

At an economic conference in May 2012, Roubini predicted a coming “perfect storm” of economic calamities and a few months later he announced conditions for the storm were already lining up.  

Reacting to the crisis in 2008, central banks had room to cut interest rates to pump money into the economic system.  In 2013, with interest rates near zero and slower growth jeopardising debt repayments, solvency is the new problem and there’s not much more monetary policy can do to fix things.

Roubini’s perfect storm prophecy consist of four components:

•    The Euro Zone crisis is getting worse.

•    The US economy is weakening.

•    China’s growth rate is unsustainable.

•    Increasing tensions over Iranian nuclear capability could lead to higher oil prices.

Europe

It’s not out of the question for the Euro Zone to splinter, perhaps as early as 2013.  The first domino to fall could be Greece, which Roubini says may abandon the Euro in a matter of months.  In the next few days, business sources claim Greek officials will meet with German and French leaders to ask for a two-year extension in the implementation of their austerity program.  The Greek Prime minister wants to extend spending cuts over four years to spur growth in the Greek economy.  

The Greek problem of austerity versus growth plagues the entire region.  In layperson’s terms, indebted Euro Zone countries are caught between a rock and a hard place.  Slowing GDP in the aftermath of the GFC made sovereign Debt to GDP ratios unacceptable to wary investors, so stringent austerity measures were implemented in some countries to signal a serious effort to reduce debt.  

The United Kingdom is a prime example but the vicious cycle began when austerity slowed economic growth even further, plunging the UK into recession.  In essence the problem is which comes first, spurring economic growth or imposing austerity measures?  Spain, Italy, Portugal, Ireland, Greece and the UK all led with austerity measures and are now in recession.  Global sovereign debt investors have refocused their concerns from debt to growth and are demanding higher interest payments making it even more difficult for affected countries to reduce debt as borrowing costs rise.  

Roubini sees what he calls a Balkanization of European banks as these institutions become less willing to make loans across borders and begin to deny interbank credit.  Capital is already in flight from countries like Spain and Roubini sees the potential for bank runs in periphery European countries.  The banking system has become even more burdened as countries try to improve sovereign balance sheets by moving public debt onto the banks.  Instead of bailout funds adding to a country’s debt they are going directly to the banks.   

Unlike many other doomsday forecasters, Roubini sees potential solutions, but doubts they can be implemented.  He states austerity measures should be introduced gradually and recommends a full fiscal union with a unified banking system with deposit insurance across the entire Euro Zone and the issuance of Euro-Bonds.

However, Roubini sees little chance of these solutions coming to pass since Germany resists these policy measures.  With the strongest economy in the Euro Zone it is not hard to understand why German leaders are concerned about increasing risk to their own taxpayers from more integration of European economies through fiscal and banking policy changes.

For Roubini’s perfect storm to come to pass the Euro Zone crisis must end with the dissolution of the zone.  

However, his specific concerns are replete with warning signs.  In the coming weeks investors can see whether or not Greece gets its requested extension of the time frame for implementing austerity measures.  If they fail, it could be interpreted as a sign that Greece may be the first country to exit.

Spanish and Italian bond yields are also signals to watch.  Rising yields increase the odds these countries will be forced to go to the ECB and the international finance community for full sovereign bailouts, surpassing the existing framework for bank bailouts.  

Finally, watch what German Chancellor Angela Merkel does, not what she says.  You may recall earlier in the European summer she adamantly opposed ECB bailout funds going directly to Spanish banks and then reversed herself.  As bleak as this situation seems, there are still potential solutions that can preserve the Euro Zone, as Roubini himself has outlined.

A few short days ago RBA economist Guy Debelle, expressed the opinion that the crisis is approaching its end and it likely to be resolved at the 06 September meeting of the ECB (European Central Bank).

The US

The perfect storm scenario calls for weakening US economic conditions to wilt into a full-blown double dip recession.  Roubini cites weak GDP growth and job creation.  

The US is also approaching the looming “fiscal cliff,” scheduled in January 2013.  Unable to agree upon a debt reduction package following last year’s disastrous debt ceiling crisis, automatic spending cuts will begin to go into effect in 2013 and tax cuts for all income groups will expire, leaving consumers with less disposable income.  The subsequent decrease in consumption may grind GDP growth to a halt.  

His final concern about the state of the US economy is continued political gridlock with ongoing battles over the US debt ceiling.  Regardless of who wins the election, Roubini sees the potential risk of more government shutdowns and additional credit ratings downgrades.

Here again the US economy will provide warning signs and some good news out of the US recently is worth noting.  Although US job creation data in May and June was dismal, indeed, the July report surpassed economists forecasts of 100,000 jobs added, by around 60,000.

In addition, recent retail sales figures, industrial production, and core inflation rates, were all better than forecast.  A survey of U.S. homebuilder sentiment showed that index reaching a five-year high.

China

Roubini’s broader prediction is for a hard landing in China in particular and emerging market economies in general.  He has been bearish on China’s infrastructure investment driven economy for some time and claims their current efforts to shift to an economy more driven by domestic consumption will be “too little too late.”  He feels the upcoming leadership transition in China may lead to divided opinion over the pace of needed reforms to raise domestic consumption’s contribution to GDP.

While some experts feel falling commodity prices will boost consumer spending globally, Roubini disagrees; he regards commodity price falls as a clear signal that the global economy, particularly emerging markets, is slowing.

A “hard landing” in China is Roubini’s third ingredient for the perfect storm.  But what exactly is a hard landing?  The enviable 7.6% GDP for their latest report is interpreted as both positive and negative signs.  Positive in that the Chinese government has been aggressively trying to slow down growth to cool inflation and negative as evidence the economic woes of China’s largest trading partner – the Euro Zone – is crushing export demand and domestic consumption has not risen enough to contribute to GDP growth.

While there is no general agreement on a specific GDP number that would indicate a hard landing, the general definition of a hard landing is a severe slowdown following a period of rapid growth.  Hard landings generally happen in response to overly aggressive policy responses and the Chinese government’s infrastructure investments in the wake of the GFC certainly qualify.  

Few believe that the Chinese government will take no action but what they actually do could be a sign of worry or welcome relief.  Right now they appear to be satisfied with a gradual approach with small interest rate cuts and modest increases in spending.  Watch for any evidence in increased consumer spending in China, but in reality their fate is intertwined with what happens in the Euro Zone.

The Middle East

War in the Middle East over Iranian nuclear ambitions and the impact on oil prices is the final component of the perfect storm prophecy and the most difficult to assess.

On the one hand the US government states that Iran is not close to producing a nuclear weapon – and therefore diplomatic initiatives and sanctions have time to resolve the crisis.

On the other hand, Israelis are ready to launch a pre-emptive strike.  

US President Barack Obama has asked Israel to delay an attack to give non-military options more chance to work, something Roubini doubts will happen.  The US presidential election may impact Israel’s timing as Republican contender Governor Mitt Romney has already expressed support for an Israeli strike.

This is a serious issue that often falls off the radar screen of investors as European news tends to dominate.  Israel’s outgoing civil defense chief Matan Vilnai says Israel is ready to go to war.

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