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US sub-prime
US recession on the cards
August 17, 2007
Clifford Bennett, FxMax
Sub-prime is just the epicenter. The force is leverage, or the unwinding of it, and this process will quickly spread to all CDO markets. Clifford Bennett reports
The Australian equity market is being impacted by the same forces Europe and other global markets are experiencing, those forces are emanating from the US. This is not a sub-prime crisis, but a crisis of extreme leverage. The sub-prime market was merely the most vulnerable part of the financial system to a touch down of reality.
The crisis has to some degree been brought about by the very factors that have generated the grand bull trend in global equity markets over the last 20 years. The coming to age of superannuation the world over has lead to ever increasing amounts of money desperately searching for a home anywhere a yield could be found, especially during the period of historically low interest rates just seen.
A sell story of a bundled group of high risk loans being low risk was somehow able to fly in such an environment. Sub-prime was the epi-centre and the next outer ring of this expending crisis will be CDOs (collateralized debt obligations) in general. This is when things will get serious and some banks may be at risk. Running parallel to this process, is the broad based unwinding of speculative positions in financial markets from Oil to New Zealand dollars to Gold and back again.
There is a definite crisis gripping global markets at the moment, but that ultimate safe haven Gold, is heavy, in price as well as carry. A large part of the Gold rally has been speculation, albeit I believe sound speculation based on the increasing wealth of cultures where Gold is an important social attribute such as India and China, and increasing industrial demand.
The current crisis is forecast here to be on-going for several months, and so further demand for Gold as again a currency of last result is likely to increase significantly. In the first instance however, Gold like other markets, is subject to the unwinding of a massive degree of leverage. Also as for other markets, the redemption forms now flying supersonically onto the desks of even sound and profitable hedge funds, will lead to a steady selling of rallies for several more days, and perhaps weeks.
Once this unwinding of leveraged long positions is completed however, Gold will be like a ball that had been pressured beneath the waters surface, suddenly released. Expect a very sharp rally to emerge sometime in the next few days to weeks that will carry Gold to US$750 or US$800 extremely quickly. For the moment perhaps some further downward pressure for just a bit.
The implications for Australian financial and equity markets are clear. Considerable risk will be the dominant theme for several weeks or months.
The Australian dollar has enjoyed the buoyant benefits of leveraged hedge funds speculating on its continued climb for a couple of years now. Those long AUD bets are already being unwound for everyone to see.
As the first to forecast the AUD at parity in the years ahead I also signaled the onset of a 2 to 4 cent correction a week in advance, but I now believe that was a modest call. The AUD could test .8250 or lower before a recovery begins. I still believe the AUD will achieve parity, but for reasons of US dollar collapse as much as Australia’s high yield and doorstep of Asia commodity producer niche. Right now however the risk is still to the downside.
The continued weakness of the AUD is another factor that will spill onto the desks of equity funds holding long Australian equity positions.
The initial equity market impact being felt in Australia is due to some headlined local exposures to the sub-prime market, but when we expand the crisis to all CDOs it is not hard to see how things can get a lot worse before they get better. Regardless of the true nature of exposures, which it must be said few investment banks are able to accurately quantify even for themselves, the fear of how deep the pain may run could see the Macquarie Bank share price down quickly toward $61 before any substantial recovery ensues, and similar experiences are likely for other entities. Overall our scenario laid out last week of how this could all unfold in a macro sense of a US recession by year end, a slight hiccup in the global economy, a sustained bear trend in equity markets, overlaying a simultaneously firm and robust global economy, remains on track.
The continued driver of the global economy really is that the growth of intra regional trade around the world, has created a far less US centric global economy than we have ever seen. China and India should continue to boom, though if there is a danger of a global recession or depression, it is from China. My favoured scenario remains a continued strong growth path for China of around 10%, to 14% at times, and therefore continued demand for commodities. Though commodity prices may have peaked, they will stay firm albeit with volatility.
The risk to this rosy global economy scenario is however, and of course, its primary driver. China is a land where speculation comes as easily as eating, and we should not under-estimate how leveraged some participants in markets there are. Should the “unwinding of leverage” virus spread to China, and I am not speaking of sub-prime but just leverage per see, then the world would exposure enter a serious phase of gloom a and doom as expectations for commodity prices and producers, as well as strong global trade, plummeted.
The forecast is, an expanding leverage crisis continuing to pressure equity markets for some time, the US being hit by a housing construction slow down and financial markets crisis at the same time enters a recession, the global economy takes a breath and then returns to firm robust growth.
The risk is, China catches the same cold. I rate the risk a 15% only chance, but it might be a good idea to keep a close eye on the Chinese stock market in coming weeks for a lead as to whether the global economy really can just keep marching on without the US.
Technically the important immediate support around 5,930 5,910 is only just managing to hold. Any weakness in US markets today could see a tumble through that support zone that would likely lead to a snow ball sell off toward 5,500, perhaps 5,020. We had an encouraging rally yesterday, which as expected melted rather quickly. We still need to get back above 6,185 to be sure some form of absolute low had been seen. For now further downside is still the dominant risk.
Clifford Bennett, Chief Economist, FxMax. For further information regarding FxMax please email Clifford Bennett.
More articles from this week's newsletter:
Markets: Weathering the storm
Companies: Unloved offshore miners - part 2
Resident Trader: Running scared
International: Stronger Asia better able to deflect ripples
Credit: Eyes on central banks after US Fed move
US sub-prime: US recession on the cards
Markets: The fear spiral
Smart Investing: Tax takes shine off a great year
Stock of the week: NAB
Companies: Some transport worth catching
Software review: Amibroker
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