We saved the most momentous for last. Nothing caused more angst in 2015 than China...namely whether or not China is heading for a "hard landing". A hard landing implies the economy will slow down more than expected. The implications of a Chinese hard landing are significant because:
- China is the largest "growth engine" in the world. No one really knows what China's GDP is but official records should have it somewhere around $11T. If China can grow at 6% that is an increase to global GDP of around $700B annually. The US is growing around 2% a year on a $18T economy or $360B or so.
- Many commodities and therefore many countries, depend on Chinese demand. In some cases, especially around infrastructure commodities, China has been 30%-40% of world demand. That demand cannot be replaced anytime soon by anyone else.
- The developed world has deflationary problems. As China lets the yuan depreciate it effectively exporting deflation to the developed world. Deflation is a big problem for developed countries with large amount of debt and China is a massive exporter to these countries.
- Most importantly, no one is really prepared for a significant slow-down and the psychological impacts would be tremendous.
The last point has been made recently by both Paul Krugman and Howard Marks. Mr. Marks (one of the best distressed investors of all time) quotes Mr. Krugman in his latest letter. We are going to include his entire analysis because there is no way we could say it better than him:
In other words, a Chinese hard landing wold be made worse because of fear. The economy and the markets are reflexive, meaning the participants actions affect them. If people get fearful they sell stocks and the market goes down. The market going down affects the economy. It is all interconnected.
So why not run for the hills? To an extent we have through our increased holdings of cash. But at the same time, it is important to remember that we are all scarred by the Great Recession and that is the heuristic that we go to time and time again. Is this the next big one? Is the world going to fall apart?
We can have a recession or a Chinese hard landing without the entire world economy imploding. That does not mean stocks won't do badly, but it does mean a sound defensive portfolio with cash should perform okay. Going fully to cash may mean you miss the next big downturn but it does not mean you will be able to get back in at the right moment. Timing the market is generally a fools game. As usual Mr. Marks puts it better than we could on our own: