One Thing That Could Go Wrong Is China

Fridays' bad jobs report aside, it's hard for people to sink their teeth into anything that really worries them right now.

The consensus view of the economy is that 2014 will be the best year since the crisis, and that we're probably reaching "escape velocity" right about now.

Europe isn't looking all that pretty, and some economies are especially weak, but most people believe in an ongoing muddle through.

Japan looks like it will probably expand at a decent base (by Japanese standards).

If there's one area of concern for people right now, it's probably China.

That's the view expressed by Morgan Stanley strategist Joachim Fels, as expressed in his latest Sunday Start note:

Conversations with institutional investors and colleagues at our LatAm conference also reinforced my impression that there is a very strong consensus in the investment community about the global macro outlook for this year. People are constructive on economic growth in the advanced economies, especially for the US but also for Japan and Europe, and think EM economies will lag but do somewhat better this year than last year. They are bullish on equities, moderately constructive on credit, and moderately bearish on government bonds. In currencies, everybody loves the dollar, especially against the yen but also against the euro. It's important to note that this broadly gels with our baseline macro views and that the consensus is more often right than wrong. But still, I can't help that slight feeling of nausea when everybody holds the same view. What could go wrong?

One thing that could go wrong is China. The consensus view is that the authorities have everything under control and that the transition from export- and leverage-driven growth to consumption- and reform-driven growth will go smoothly. Our worry is that this transition, while likely to be successful eventually, will turn out be more tricky in the near term, mainly because financial conditions have tightened considerably, as evidenced by higher money market rates and bond yields. This in turn is likely to produce a sharper-than-expected downturn in China's growth during the first half of this year, which may well lead to renewed fears of a hard landing. A related worry is that the wobbles in China could contribute to a risk-off move in Asia (and perhaps globally), which would benefit the Japanese yen temporarily. In fact, our currency team, led by Hans Redeker, who called the 4Q13 rally in USD/JPY right, looks for a counter-rally in the yen to below 100 in the current quarter. My impression from many client conversations is that not many people are positioned for such a move.

One thing that makes China interesting is not just the risk of some kind of sharper-than-expected downturn, but also the stakes. China has an outsize trade relationship with so many countries, that a sharp downturn would have significant ripple effects towards those exporting into the boom.

Fels isn't the only one who thinks China is where the world is particularly interesting.

George Soros recently laid out his concerns in a piece up at Project Syndicate:

The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam. That model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35% of GDP, and its forced savings are no longer sufficient to finance the current growth model.This has led to an exponential rise in the use of various forms of debt financing.

There are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008. But there is a significant difference, too. In the US, financial markets tend to dominate politics; in China, the state owns the banks and the bulk of the economy, and the Communist Party controls the state-owned enterprises.

In conversations, we've heard others express similar concerns.

Some important notes need to be made. One is that people have been warning of a Chinese hard landing every year for years. There might also be some element of worrying about China by default, since it's hard to pinpoint risks every year.

But if there is a consensus view on the big risk to the global economy in 2014, then we'd say China is it.