The one forecast Buttonwood can safely make for 2008 is that the consensus will prove to be wrong. Although many anticipated a fall in American house prices for 2007, for example, few expected the scale of the ramifications for financial markets, as a whole system of structured finance appeared to unravel and the banking system was plunged into crisis.
In one of the defining phrases of 2007, the author and investor Nassim Taleb has called these occurrences black swansunexpected events that have enormous consequences. These are, by definition, very hard to forecast. One approach is to make several wild guesses in the hope that one will prove right; Saxo Bank, for example, predicts, along with a further doubling of grain prices, that Ron Paul, the Texan Republican, will be elected president. Buttonwood will take the more modest approach of highlighting a couple of areas that could burst out of the background to grab next years headlines.
The first is commercial property. The very pressures that threaten further falls in the housing market (a slower economy and tighter credit) tend to affect business occupiers. And past banking crises have stemmed more often from the commercial market (which has traditionally shown more violent swings) than from the residential one.
The British commercial-property market has already shown signs of cracking, as recently became clear when a fund run by New Star Asset Management marked its assets down by 18%. The Bank of Englands Financial Stability Report, published in November, revealed that lending to commercial-property companies now comprises 9% of all domestic lending, a higher proportion than at the previous peak in 1989-90 (which was followed by a property crash).
Other warning signs are plain to see. In 2006 British commercial property reached the moment defined by Hyman Minsky, an American economist, when investment becomes driven by speculators. That year the rental yield on property fell below the cost of financing, implying that investors were counting on prices to keep rising to make money.
Britain is far from alone. In Spain and Ireland boom also seems to be turning into bust. And then there is America.
The fundamentals still look favourable; office vacancy rates, for example, still seem to be low. But the credit crisis may have an effect, nonetheless. On December 17 Centro Properties, the Australian owner of 700 American shopping malls, defaulted on some $1.1 billion-worth of loans.
A second area of danger is eastern Europe. Former iron-curtain countries have been popular investment destinations for many years on the grounds that their economies and financial markets are bound to converge with those of western Europe. But as Ian Harnett of Absolute Strategy Research points out, this has led to a dangerous trend within the ex-communist countries: the desire of consumers and companies to borrow at low interest rates in foreign currencies.
The temptation is understandable. Hungarians borrowing in Swiss francs win nine percentage points of interest savings a year. The risk, of course, is that the forint devalues or depreciates. If that happens, the burden of repaying the foreign debt then becomes crippling. That was the lesson of the Asian crisis of 1997-98.
Some economies are more exposed than others. According to Gillian Edgeworth, an economist at Deutsche Bank, 51% of Hungarian credit is in foreign currencies. But the trigger for a crisis could come from anywhere: Bulgaria, where foreign-currency debt of 48% of GDP is laced with a current-account deficit approaching 18% of GDP; Latvia, where the current-account deficit is nearly 25% of GDP; or Kazakhstan, where Fitch, a rating agency, just changed its outlook to negative from stable. And if confidence goes from one of those markets, it could spread to the whole region.
Would a crisis in the former Soviet block really matter It would if it struck just as Americas economy was slowing sharply and as weakness was afflicting both western Europe and Japan. As the subprime crisis showed this year, it is hard to tell which banks and investors are at risk until the bad news comes out. Swans can give you a nasty peck.
The Economist Newspaper Limited 2007