Introduction
This is an interesting time to write a weekly forecast. Originally, I was planning to write a macro forecast predicting continued weakness of the JPY and the general Asian economic predicament. However, ever since the two Bear Stearns hedge funds erupted last week, liquidity has plummeted. There are so many parallels with Long Term Capital Management, whether it's risk-management equations that have proven hopelessly outdated, a large default that nobody saw coming, historically low (lower than 1998) spreads between high- and low-risk debt, it's hard to know where to start.
Sincerely,
Alex Forshaw, Editor
Echoes of 1998
Because permabears tend to predict nine out of every two LTCM-style system shocks, the newsletter is skeptical that the collateralized debt obligation (CDO) crisis will be the economic cataclysm everyone predicts. Furthermore, shocks generally do not occur because of an unpredicted explosion in one sector of equity or debt, simply because no one sector is large enough to inflict that kind of damage by itself. Shocks occur because an unpredicted explosion in one sector triggers more, less-predicted explosions of greater magnitude in other sectors. People on and off the Street have been talking about it for months, and not very many people are surprised that so much “toxic waste” is finally bubbling up to the surface. Furthermore, there are lots of hedge funds on the other side of most subprime-mortgage bets (subprime loans being the “collateral” on which many of the CDO derivatives are based), and they will emerge as huge winners from a meltdown scenario. (About three weeks ago, several funds filed a flurry of complaints with the SEC after investment banks moved to prop up the subprime dealers on whom the banks' piles of CDOs were based.)
What could turn the CDO problem into a larger crisis would be correlated meltdowns in other countries, notably Asian ones, which are highly dependent on the US consumer. Japan's economy has wheezed its way to modest growth in 2005-07. However, Japanese assets have performed atrociously relative to almost any foreign currency, because the yen has depreciated so much. Investment has shunned Japan since 2005, and Shinzo Abe's government shows no signs of tackling Japan's myriad economic problems to bring foreign investment back into the country. Furthermore, the BoJ will almost certainly not begin its long-overdue series of interest rate hikes in July. The market expects an August raise, but the BoJ has come under increasing political pressure, and its credibility wanes with every passing day. It's not a good place to begin with, but considering how much of that growth is dependent on American consumption, a US slowdown would plunge Japan into its fourth deflationary recession in two decades.
China's economy is even more export-dependent than Japan's. Overnight, Shanghai's SSE dropped almost four percent (which is pretty normal for the SSE, frighteningly enough); other, more mature Asian indices dropped an average of approximately .75 percent.
Chinese companies already suffer from a gigantic glut of overinvestment and low profit margins (thanks to extremely low-interest loans), which has in turn caused domestic inflation to significantly exceed official figures. Thus, the Chinese hoi polloi have been earning negative real interest rates on their deposits. When the Chinese securities regulator allowed Chinese to invest lots of their tax-sheltered deposits in the stock market, the SSE and its sister Shenzhen index rocketed upwards; the Chinese were tiring of negative real interest on their savings.
Anecdotally, at the same time that the Chinese equities bubble has slowed, Chinese banks have come under massive pressure to meet rising withdrawal rates, on top of managing their pile of non-performing loans (“bad debt” = loans that won't be repaid) that probably exceeds 40 percent of China's GDP. As a result, Chinese banks have come under massive pressure, while Chinese equities are staggering to the end of a huge bubble (over 300% appreciation in 18 months). The Chinese economy has come under heavy strain at both ends. Countries don't grow at 10% annually for 30 years without a lot of pent-up inflation and phony accounting. Add to it pollution problems that make Los Angeles a comparative garden of Eden, and huge riots against local government officials who kick families out in favor of new (unnecessary) business projects, and unrest will become a major factor in future Chinese economic and political uncertainty.
(The newsletter is waiting to see Chinese protesters wearing T-shirts that say, “My environment was completely polluted, my bank savings were completely wiped out, my stock holdings went to zero, and all I got was this lousy Made in China T-shirt,” but we won't hold our breath.)
So what does all this have to do with the Bear Stearns CDO debacle?
We have not seen the last of the CDOs, not by a long shot. Bear bailed out its weaker fund -- which had to meet $63 million or so in margin calls -- with $3.2 billion. The larger sister fund is in twice as deep. Will Bear come up with $6.4 billion to bail it out?
By itself, this isn't such a big deal. It is to Bear, of course. It's also a huge problem for the other banks that collectively bid up the CDO market, and now face no buyers. But large hedge funds are on the other side of this, quietly waiting to feast on Bear's carcass. If the CDO collapse is large enough, however, it will be devastating to the private-equity empires which, for the past several years, have essentially arbitraged cash flow and interest rates. If interest rates rocket up, as they did during the LTCM meltdown, private equity will follow Bear Stearns to the torture rack. (Note how Blackstone, one of the largest private-eq combines in the world, was at Bear Stearns' side trying to help them quietly unload their worthless paper, to keep interest rates as low as possible. Skyrocketing interest rates would be Blackstone's worst nightmare.)
Will that trigger other long-deferred corrections in markets elsewhere in the world? The newsletter does not pretend to know. We instinctively roll our eyes at the “Dow 6500” crowd, but the economy hasn't been on so many pins and needles in years. However, more tremors are on the way. Large banking institutions are approaching a break point, and most of the rest of the world's economy is not any better prepared than the United States to contain the fallout of a shakeout in higher-yield credit.
The Bottom Line
USD: The US dollar dropped against almost all currencies last week and there is clear indication of further weakness of the US dollar in the coming week. This can mainly be attributed to the higher probability that interest rate will most likely be reduced. In addition, there is a lot of negative economic data such as secondary housing market sales and consumer confidence (negative consumer confidence release by Michigan last week). However, with further speculation of a rate decrease expect the USD to continue to fall across the board.
For what they're worth, here are our short-term forecasts. We want to emphasize that these are even more tenuous forecasts than usual.
EURO: With very little economic data being released for the Euro next week, expect the EUR/USD pair to be bullish due to poor USD data and heightened expectations of a cut in interest rates. Buyers should look to buy on dip and the overall outlook should be bullish for the week.
Pound: The GBP/USD will look to break the 2.0 mark again this week and buyers should continue to buy on dips. The GDP for the pound is also being released this week, this economic indicator should not have a major impact on the currently rally and the market will continue to see a bullish trend.
CAD: The Canadian dollar has been following a very bullish trend over the past two weeks due to high gas prices and inflation prone figures. With less economic data being released, look for the CAD to trade within a fairly small and stable range.
Yen: With the Yen weakening across the board, look for a good trading range for scalping.
Overall Status for the Week:
USD: Bearish
EURO: Bullish (EUR/USD Pair only)
CAD: Bearish
Yen: Neutral
--Alex Forshaw & Sumant Yerramilly,
http://www.bestwaytoinvest.com
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