World Economies - The Tide's Going Out

It's open season on skinny dippers! As the tides go out worldwide, voyeurs are getting an eye full of who was swimming naked. It's all fun until someone has to mark-to-market. Investors all over the globe are facing a slowdown and now scrutinizing the risks they are taking at home, and questioning the returns they should be expecting in a low real interest rate environment that looks to be spreading. Note that real rates in the US and China are already negative.

Let's take a brief tour of the latest carnage in pictures and figures.

The Shanghai composite Index is an absolute bloodbath (excellent chart below from Bespoke Investment Group). Either you believe that markets are completely inefficient and express no actual information about the underlying company fundamentals, or something has changed radically in China. I'm not just talking about giving up some ill-gotten gains related to over-enthusiasm for the China investment theme and the Olympics. The 60% decline in this stock market, a give back of over 2/3 of a 502% up-move, is a shellackering you don't see very often. I will wager that millions of people in China are now sitting on losses, despite investing in a stock market that had underperformed the world for a decade before its meteoric rise. Why?

I personally believe that China has grown way too fast, as I opined in an April 2008 piece China Update - Olympian Challenges. In it I stated "Economic growth can be like heroin, though, you keep needing more and more and it gets pretty ugly when you get less. Due to imbalances in the Chinese economy, the country has grown to rely on high rates of growth." Folks appear to be more than a little worried about these imbalances. But regardless, China doesn't have to implode for Chinese stockholders or the world to notice, it just has to slow down.

Seperately, the first negative GDP quarter registered in the Eurozone since 2001 was reported yesterday. The linkage to the U.S. is definitely being felt here, but the Europe has it's own home grown problems as well, particularly in the countries that boomed in recent years. Here's a chart on growth in the biggest economies there from The Economist.

Check out this chart of the oil correction from Futures.TradindCharts.com. I say correction, because I am not making a bearish call on energy from these levels in this piece, although I had been expecting commodities generally to weaken for the last six months due to slowing world growth (so i was a little early).

The impressive thing here is how fast this freight train of a bull market has wilted. I am showing you a less dramatic-looking daily chart, so you can see that it took about 9 1/2 months for oil to rocket from $110 to $140, but only 4 1/2 weeks to give it all back. This smacks to me of a market which was run up by weak players, who all bolted as soon as it turned south. Is it any wonder? As Noah has mentioned here before, oil in particular and commodities in general were the last one way trade. Here's the vicious cycle players were depending on.

Higher oil prices (and commodity prices) sap consumer spending power; this pushes more homeowners into default on their rapidly imploding properties; which causes more losses for banks and tighter credit, further slowing the economy; the weak economy leads to a weaker dollar, which causes commodities and oil to inflate more. The Fed can't ease rates due to a weak dollar (and inflationary pressures that result from it), their easing isn't translated into lower borrowing costs anyway because banks can't afford to take on any more risk while their current loan portfolios are blowing up and the Fed can't raise rates to help cushion the dollar out of fear of killing the banking system and the consumer. PREFECTO! the ultimate one-way trade.

The only problems with this trade were: What if the entire world economy started to slow causing unemployment to rise, and the ability to pay higher prices evaporates? and what if high prices actually do what they are supposed to and kill demand? It's always a guess what the elasticity of demand for any particular item will be and necessities like food and fuel seem like things people might accept a big price hike on before they cut back their consumption. But, of course, besides demand destruction, there's always substitution and trading down, which we are seeing in spades. You can see the contrast between Macy's Q2 results wherein sales fell 3% and Wal Mart's. We have all heard about the switch from driving cars (gasoline) to mass transit (electricity/coal).

So what's the next great one-way trade? In my book there is none - there will be the occasional distressed fire sale, but it will take deep pockets and a very long-term perspective to participate here....no ETFs I'm afraid. It is going to be a long, slow grind for the imbalances worldwide to get worked out. I have always believed that the imbalances were worldwide, not just because of the scary things I was reading about the London commercial property market, the Spanish and Indian housing markets and Chinese fixed investments, but because money was incredibly cheap worldwide and when money is cheap people do dumb things....sort of like when alcohol is cheap. Now that money destruction has begun to spread around the world, we will find out just how far and how deep the "mal-investment" or mis-allocation of capital around the world went.

On the positive side, I don't see inflation expectations getting out of hand in this environment (see my piece Oh Behave Inflation - NAIRU to the Rescue). Additionally, with the US already facing up to its bubble and cutting rates significantly/monetizing the debt, the dollar will look somewhat more appealing than the currencies of countries that are just about to start cutting rates. Check the chart below of the recent dollar strength. I don't expect a straight up move and it should pull back from the recent pop, but I think the one-way trade is over.

So should we really be rooting for a global rout? It's not going to help our export growth and corporate earnings, but it's an improvement from the vicious cycle of dollar weakness/inflation/consumer devastation. The tide will come back in eventually, but until then, as the Brits would say, "Keep your swimming costume on!"

From the Blogosphere

Investors less worried about inflation - Merrill poll

The party is nearly over - Eastern European bubbles

The South Sea Bubbles Again

Economic slump hits Spain hard after 14-year boom

Japanese economy shrinks, adding to recession fears

Euro pinned down as euro area growth contracts

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