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Monday, September 10, 2007

The Final Blow?

This week should be interesting. The deterioration of key economic indicators around the world is starting to become obvious. I built my short positions early last week when the S&P500 was in the 1480 – 1490 are. My volatility adjusted stops give me both the necessary room and protection. I am onside and have the ability to hold out for my preferred scenario: A retest of the lows.

Global Growth Threatened as U.S. Contagion Spreads (Update1): “This time, when the U.S. sneezes, the rest of the world may well catch a cold.

Global economic growth looks likely to slow markedly in the months ahead as further weakness in the U.S. infects Asia and Europe. That would represent a shift from the last 18 months, when the world economy proved immune to a U.S. slowdown and grew at an annual clip of more than 5 percent.”

Economists have been arguing that the health of the economies of the world were no longer as correlated as they once were. They misunderstand the impact and consequences of globalization of both economies and financial markets. Should the US consumer falter, the consequences will ripple through the global supply chain. For example, the manufacturers of Widgets in Vietnam will have to idle their factories because the orders from McBoxStores have slowed. For example, although German banks were forbidden by law from giving out stupid high LTV mortgage loans at home, they could buy them in huge quantities and with huge leverage from abroad with the click of a mouse. We are all connected now…

Japan's Economy Contracts a More-Than-Expected 1.2% (Update6): “Japan’s economy contracted at almost twice the pace forecast by analysts in the second quarter, reinforcing speculation the central bank will leave interest rates unchanged this year.

The economy shrank at a 1.2 percent annual rate in the three months ended June 30 as business spending slumped, the Cabinet Office said in Tokyo today. The government initially forecast a 0.5 percent expansion.”

This makes a rate hike in Japan an impossibility and illustrates just how quickly things can deteriorate.

Wall Street Credit Costs Soar on Spread to U.S. Rates (Update1): “Wall Street is getting no benefit from the biggest bond market rally in five years.

Sales of U.S. asset-backed securities, such as bonds that repackage subprime loans or credit card receivables as well as collateralized debt obligations, fell 73 percent from a year earlier to $30 billion last month, according to Deutsche Bank AG, Germany's biggest bank.”

On top of that, all the main players on Wall Street are stretched thin by massive prior commitments that don’t look so lucrative anymore…

“The five largest U.S. securities firms -- Goldman, Morgan Stanley, Merrill Lynch & Co., Lehman and Bear Stearns -- will have to fund $75 billion of loan commitments to LBOs at a loss because most investors have stopped buying that kind of debt, Citigroup Inc. analyst Prashant Bhatia estimated last month.”

But then again, none of this should really be much of surprise.

“The securities industry has relied increasingly on borrowed money to boost profits and returns for investors. In the first quarter, Goldman had 24.7 times more in assets than it had in shareholders' equity, and the firm's return on the tangible portion of that capital was 44.7 percent. Five years earlier, in the first quarter of 2002, the leverage ratio was 16.8 and return on equity was 15.4 percent.”

First, returns of 44.7% are not sustainable. EVER.
Second, returns like that are NECESSARILY a product of greater risk. Understand that.
Third, mean reversion CANNOT be prevented. Only slowed or postponed.

Debt Market in `Pivotal' Test as $140 Billion Matures (Update2): “Banks and companies need to refinance almost $140 billion of commercial paper in Europe by the end of next week and may push up yield premiums on corporate bonds, according to Deutsche Bank AG, Germany's biggest bank.

“This could be a pivotal seven to 10 days,” Jim Reid, a credit strategist at Deutsche Bank in London, wrote in a note to investors today. “This will inevitably lead to wider corporate spreads, especially in high yield.”

Borrowers are paying the highest costs in six years for commercial paper, IOUs maturing in 270 days or less, because of losses from assets related to subprime mortgages. The yield in the U.S. has soared to 6.33 percent for 30-day debt from 5.48 percent on Aug. 9.

Almost $60 billion of the commercial paper due this week and next is owed by conduits, firms set up by banks and companies to invest in longer-term assets, according to Reid. The debt is backed by bonds including asset-backed securities, as well as car loans, mortgages and trade receivables. The remaining $80 billion of commercial paper is unsecured.”

Despite serious efforts by all the major central banks, the debt markets are currently seized up. How and when this is resolved will determine the extent of the carnage.

OPEC Will Probably Maintain Output Limit, Members Say (Update3): “OPEC will probably maintain its oil production targets, resisting calls for more supply because of concerns demand may falter as U.S. economic growth slows, said officials from six member-nations.”

OPEC can’t resist. Greed triumphs again. An increase in production would lower prices immediately and these would certainly go a long way to help alleviate the pending global slowdown. Could it be that high energy and commodity prices will strike the final blow and drag down a global economy already wounded by the bursting of a global credit bubble?