As we can see, over the past several months, there had been a lot of volatility in the global financial markets. As we said before in Why is the market so easily tossed and turned by dribs and drabs of data?, without the proper framework of sound economic theory, the outcome is that the lack of deductive reasoning and insights brought about the situation where the

… market gets tossed and turned by every minute variations of statistical information from economic reports. The end result is confusion and volatility.

Clearly, this shows that the media, pundits, investors, traders and other market participants do not know what is going on.

Today, we will present to you what we believe to be the long-term big picture. Our opinion is by no means a prediction in the forecasting sense- rather, it is just our feeling, intuition and guesses (maybe one day in the future, this opinion will be famously known as ‘insight’ or ‘foresight’?). Therefore, do NOT take our opinion as financial advice- we are not financial advisers and our conviction is that one should be ultimately responsible for one’s own investment and financial decisions.

Okay, here comes the meat…

Firstly, our belief is that the US economy is heading for a hard landing. Currently, Ben Bernanke’s forecast is that economic growth will pick up in 2009 after a possible mild recession. This is also the belief of the market, as it tentatively believes that the credit crunch is abating. We are sceptical of this view. After all, years of accumulation of bad debts, over-leverage, mal-investments and structural damage of the US economy cannot be simply brushed away with the turning of interest rate levers, money ‘printing,’ bailouts and sweet talks. As we explained 13 months ago in Marc Faber on why further correction is coming- Part 2, the liquidity contraction that started in the US is resulting in the process of global asset price deflation, especially house prices in the US. As asset prices deflate, this will bring about further bad debts, which in turn will bring about further deflation in a vicious cycle.

Next, as it especially applies to the Western developed world, the financial side of the economy has grown to be a major intertwined component of the overall economy. As we said before in Analysing recent falls in oil prices- real vs investment demand, the difference between the real and financial side of the economy is that the

.. real side [is] where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments.

It can be argued that today, the financial side of the economy had grown beyond its original supporting role of efficiently and flexibly allocating capital for the real-side of the economy, to the point of playing one of the primary roles in the economy. In any case, both sides are interlocked hand-in-hand with each other, which means any shocks to the financial system will affect the real economy and vice versa. To illustrate this point, take the case of Australia. With the vast majority of working Australians parking their retirement savings through the superannuation system, which in turn distributes the savings into financial products (e.g. managed funds), which in turn further distribute these savings into the financial asset markets (e.g. stock market). Furthermore, even ownership of physical assets (e.g. property) requires credit, which in turn is sourced from the financial system. And when it comes to credit, developed Western economies like Australia have been gorging on them to fund anything from credit card debts, personal loans, car loans, stock investment through margin lending, store cards, etc. Therefore, you can see that any breakdown in the financial system will have serious and dire consequences on the rest of the real economy.

For Australia, it seems to be at a sweet spot. The voracious Chinese demand for commodities have been a windfall for Australia, which has vast reserves of resources to supply the Chinese economy. That, along with a highly advanced financial system helps spread the prosperity to the rest of the nation to some degree. But the dark side of this prosperity is the build up of leverage (debts) to a dangerously high level (see Aussie household debt not as bad as it seems? and Australia has no sub-prime debt? Think again!).

Now, there are dark clouds in the horizon. The global financial system had never been as interconnected as before in the history of capitalism. You can be sure that any trouble that begins in the US financial system will spread to the rest of the world. As of today, there are murmurs about the credit crunch being the most serious crisis since the Great Depression. As the financial system rot in the US economy spreads into its real side, you can be sure that Australia’s financial system will be severely affected as well. The Australian economy (along with other Western economies with advanced financial system like the US and UK economies) are highly leveraged (i.e. burdened with far too high levels of debt) both at the retail household level and at the institutional level. Already, we are hearing about bankruptcies, blow-ups and traumatic losses in the global corporate sector (e.g. Allco, MFS, Fincorp, Centro, Basis Capital, ABC Learning Centre, Tricom, Opes, Bear Stearns, UBS, Citigroup and too many more to list). The Australian household sector is feeling the debt stress (e.g. mortgage stress, housing affordability and rental crisis, soaring personal debt levels, etc). As we said before in Rising price of money through the demise of ?shadow? banking system),

Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia?s debts are sourced from overseas. With the demise of the global ?shadow? banking system, the price of money in Australia has to rise too.

A highly indebted nation cannot afford to have the price of its credit rise without acute consequences. Thus, University of Western Sydney (UWS) Professor Steve Keen believes that a severe recession induced by debt deflation will arrive at Australia within 2 years.

The question is, will China save Australia from this?

For one, the rot in the global financial system may not affect the real side of the Chinese economy directly. This is because the Chinese financial system is still rather primitive compared to the advanced Wester economies. For example, there are still hundreds of millions of peasants toiling in the countryside. Those who migrated to the cities to toil under the factories are still not plugged into the developing Chinese financial system. Therefore, unlike the Western world, a bearish Chinese stock market does not necessarily forecast doom for the wider Chinese economy. As a result, the credit crunch that started in the US will have a limited impact on the real side of the Chinese economy. So far, this is good news for Australia (but Australia is not out of the woods yet).

Therefore, our opinion is that when the inevitable severe recession hits the Australian economy soon, the Australian mining (and related) sector will probably be the only bright spot in the darkness. In fact, we can argue that a recession may perhaps even be beneficial for the mining sector as much of the idle resources (caused by the recession) in the economy can be re-allocated to the mining sector (see How is Australia?s mining boom sucking resources out of the economy?).

But here comes the bad news.

Firstly, in a hard landing of the US economy, the real side of their economy will be crunched as well. Our theory is that this may lead to a more than proportionate contraction in the investment activities that dominates the Chinese economy, which will trigger a hard landing in the Chinese economy. Even if this theory turns out unfounded, there is another worry- the Chinese economy may not have enough resources supplied to it fast enough to maintain the trajectory of its economic growth. When that happens, the risk is that the trajectory may be shot down, resulting in the forced liquidation of all these mal-investments. The outcome is a big Chinese bust. Our article, Can China really ?de-couple? from a US recession? has the full explanation of our theory. When that happens, the last leg supporting the Australian economy will be kicked off. This is the worst-case scenario for the global economy (and by extension, Australia). Our feeling is that the coming Chinese bust may come with a time-lag after the US hard landing. If our theory about the more than proportionate contraction in Chinese investment holds true, then the time-lag may be shorter.

But yet again, this may not be all bad news in the longer run. If China’s rise is a secular event (see Example of a secular trend- commodities and the upcoming rise of a potential superpower) of the 21st century, then Australia can still climb out of this worst-case scenario.

Please note that we are not making any predictions here. Our vision is very far out into the future. Generally, the further one ventures into the future, the more likely unforeseen Black Swans will sneak in to turn one’s vision into fantasy. But as the old adage says, prepare for the worst but hope for the best.