The 6 Scariest Possibilities For The U.S. Economy

By Stephen D. Simpson, CFA | October 03, 2011 AAA
The 6 Scariest Possibilities For The U.S. Economy

If it can go wrong, it will go wrong. That will no doubt strike some as the unofficial motto of the pessimists' society, and savvy institutional investors often make decisions on that basis. While there are many things that investors can do to diversify their exposure to the U.S. economy, the reality is that for many people the health of their portfolios is predicated on the health of the U.S. economy. To that end, and a bit ahead of the upcoming Halloween season, it is worth examining some of the scariest possibilities for the U.S. economy. (For more, read 10 Reasons To Fear The U.S. Economy.)

TUTORIAL: Economics Basics

Energy Shock
An energy shock may be one of the most credible threats to the U.S. economy. Although the Arab Spring movement seems to be petering out and al-Qaida has been undermined, it is still not ridiculous to think that Saudi Arabia could be vulnerable to violent revolution. Similarly, if Israel were to inflame Mideast tensions (say, a strike on Iran's nuclear facilities) it could lead to another OPEC boycott.

Oil and oil-based fuels (like diesel) are certainly important. The average household spends between 5% and 10% of its disposable income on motor fuel, and a doubling of gas prices to the $8/gallon range could take a large bite out of non-essential consumer spending (and consumer spending is about 70% of U.S. GDP). Along similar lines, while oil imports as a percentage of GDP do not look enormous for the U.S., growth is so tenuous right now that even a half-point of GDP growth lost to higher energy costs would be a major setback.

Collapse of Credit Markets
It seems all but given that Greece is going to have to default on its sovereign debt. Greece's government has likely pushed austerity as far as it can, and the European Central Bank is running out of ideas when it comes to propping up the system. The collapse of Greece could be scary to French and German banks (which own a lot of Greek debt), but there has been time to prepare and adjust balance sheets accordingly.

More frightening would be the risk of contagion. The global financial system can probably absorb a Greek default, but a default (or even just severe strain) in Italy, Spain or Portugal may be more than it could take. Many European commercial and investment banks hold large amounts of sovereign debt and have counterparty arrangements with others who do as well. Just as the housing market crippled Lehman and the collapse of Lehman threatened the markets, so too could the fall of a major European firm.

If the credit markets lock up, the follow-on effects could be ugly for the U.S. economy. Not only will American financial firms see their balance sheet at risk, but Europe is a major market for U.S. exports. What's more, the last thing the U.S. needs now is more talk of its credit quality and higher borrowing costs.

Global Crisis
Admittedly, global crises do not follow convenient schedules; they happen when they happen and the world has to deal with them no matter what else is going on at the time. There's plenty of fodder for chaos in the world. While China does not seem inclined to start a shooting war over Taiwan, the same may not be true of North Korea and South Korea, and tensions between Pakistan and India are such that it would not take much to make that situation very volatile again. Likewise, it is impossible to rule out the risk that terrorists could succeed in a high-profile attack in a major world city like London, New York or Tokyo. (To learn more, see War's Influence On Wall Street.)

The Real Longshots
While the first three ideas are all in the realm of credible risks, there are some bigger longshots that at least bear mention and consideration. None of these are at all likely, but would clearly be major shocks to the economy.

Outbreak
Some analysts have claimed that the H1N1 flu outbreak in 2009 shaved around 1% from the U.S. economy. All things considered, this was a minor epidemic in the U.S. in terms of people affected and casualties. What would happen, then, if a true super-flu hit the United States? If there was another serious widespread disease outbreak, there would be significant strain on the U.S. healthcare system and people would stay away from public gatherings as much as possible - first impacting travel and leisure, then retail and finally the economy as a whole if workers are home sick (or staying home in fear of sickness).

State Bankruptcy
Much like the commercial real estate collapse never materialized, so too has the U.S. avoided any widespread municipal defaults. Still, there is the risk that if the economy worsens a major state may be forced to declare bankruptcy. It is difficult to estimate the impact this would have on the U.S. A bankruptcy in Nebraska or Idaho, for instance, probably would not matter a lot outside of the municipal bond market. A major state like Michigan or California would be a different story - the potential disappearance of state services and support would have significant impacts on retail spending, healthcare and some industrial operations, to say nothing of the balance sheet risk to major banks.

A State Secedes
There has not been credible talk of a state seceding for quite some time. Periodically there are fringe elements in states like Alaska and Texas that raise the issue, but it seems virtually impossible to think it would happen. Probably just as it seemed impossible to imagine Ukraine and Georgia being independent of Russia back in 1985. Given that such an event would only seem reasonable in the context of major economic collapse and political upheaval, the impact a state seceding would have on the U.S. economy is likely moot - the U.S. economy would have to be in unthinkably bad shape for such a thing to even happen. Suffice it to say, it would be a very bad thing - states like California and Texas are huge contributors in terms of GDP and tax revenue, and both are relatively young states as well, to say nothing of the energy and resource contributions from states like Texas and Alaska.

The Bottom Line
There are always plenty of things that can go wrong in an economy. In the case of the U.S., the biggest risks right now would appear to be ongoing political bickering and an inability to deal with major lingering issues like Medicare, Social Security and the inequities of the tax system. Beyond these known problems, though, are exogenous risks like energy shocks, global crises and further credit crunches. While the likelihood of any of these is low, investors should at least pause to consider how they may want to diversify their portfolios to hedge some of the risks. (For more on the financial situation of U.S., see 5 Factors That Could Send The United States Economy Into A Double-Dip Recession.)

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