What Next?

Oooh, if you read DealBreaker.com, it was really miserable to be a trader in the middle of the carnage yesterday. But it’s hard to muster too much sympathy when you recall that the average pay at Goldman last year was just over $620,000.

The real test of how serious this really is isn’t simply how badly the US market performs today (although a day as bad or worse than yesterday will focus the minds of the powers that be). If the Dow goes down by 200 points or less at its worst and corrects to a smaller loss, the panic phase of this correction will be over, and we’ll see a reassessment, and likely a contination of an equity downtrend, but at a measured pace.

The real test is if and when Bernanke and perhaps Greenspan say something to reassure the markets. If we have another comparably bad day, expect to hear from them fairly pronto. But if we have an only moderatly bad day, and either makes a statement before the end of the week, it’s a sign that they are worried about systemic risk, for example, hedge fund exposures possibly leading to further panic selling, and potentially even losses at prime brokers.

Below we have a cheery outlook, “Economic and Financial Hard Landing Ahead,” from Nouriel Roubini at RGE Monitor, my favorite bear who today looks brilliant (although a cynical friend observes that a stopped clock is right twice a day). His “hard landing” outlook strikes me as sound, but markets rarely move in a linear fashion.

Note that he makes comparisions to 1997 and 1998. Even though those financial panice did selective damage (serious harm to Thailand and Indonesia and emerging markets investors), they did not seriously hurt the world economy, and in retrospect, did not take much air out of the growing asset bubble. So as much as Roubini can point, persuasively, to plenty of evidence of fundamental weakness, we also have a Fed that floods the markets with liquidity when things get bad, and investors that are conditioned to having the Fed bail them out, and therefore buy on corrections. We will know relatively soon whether the true believers or the realists win out.

Today we had a meltdown of many stock markets, first in China, then in Europe, the U.S., emerging markets and globally. What happened today is consistent with my outlook for a U.S. hard landing this year.

The China crash had its source in the stock market bubble in China that is now beginning to burst as Chinese authorities started to crack down on these speculative excesses. This crash may be the beginning of a broader downward adjustment in the stock market in China that may lead to a broader economic slowdown in China.
Housing bubble

We also had contagion from China to other global stock markets. This contagion is a combination of the China crash and of the lousy economic news out of the US. This bad news include a sharply falling investment by US corporations (durable goods orders sharply fell), a worsening housing recession, a meltdown of the sub-prime component of the mortgage market that is leading to a much broader credit crunch in the economy. These bad economic news from the US suggest that the US will enter into a recession this year – as I predicted last summer – as early as Q1 or Q2. Even Alan Greenspan warned yesterday of the risks of a US recession.

So, the China crash and the lousy economic news out of the US led to a stock market crash in the US and in other global markets. This is not the first time that financial contagion happens from emerging markets to advanced economies: in the fall of 1997 when the Asian crisis became global a collapse of the Hong Kong market in October led to a sharp sell-off of the Dow Jones (500 points in one day), as the one we had today. Also the collapse of Russia in August 1998 led – with a short lag – to contagion to US financial markets and to the LTCM near-bankruptcy. So shocks from emerging markets can affect markets and economies in developed countries, especially when the latter have meaningful financial and real vulnerabilities, like the US today.

The US is likely to enter into a recession in 2007; and even a likely and early easing of monetary policy by the Fed will not prevent such a recession as there are too many weaknesses in the US economy: a housing recession, an auto recession, a manufacturing recession, a real investment recession (as corporations are reducing real capital investment and inventories are falling), a US consumer that is on the ropes and at its tipping point; a meltdown in sub-prime mortgages that is leading to a generalized credit crunch in the economy. It is already ugly and it will get uglier in the real economy and in the financial markets. We are likely to observe a vicious cycle where a credit crunch and a persistent sell-off in equities leads to a worsening of the real economy with a hard landing (recession) that then weakens further the financial system. One cannot rule out a broader banking crisis if a deep recession occurs.

A Fed easing – likely in the next two-three months – will not prevent a recession; it will barely put a floor on it. It will not prevent is as we have in the US a glut of housing, a glut of durable goods, a glut of capital goods. Lower interest rates will not help for the same reasons why slashing the Fed Funds from 6.5% to 1% in 2001 and after did not prevent a recession: once a glut and overhang of capital goods occurs (tech goods in 2000, housing and durable goods today) the demand for such goods becomes interest rate insensitive.

What will be the fallout of a US recession for the rest of the world? Europe, Asia and the rest of the world will not decouple from a US hard landing. If the US were to experience a soft landing Europe and the rest of the world will do fine. But if a US recession does occur there will be a significant economic slowdown in Europe, as well as in China, Asia and other emerging markets. China will be a primary victim as its excesses and its dependence on exports to the US are particularly important. So it is still the case that when the US sneezes the rest of the world gets the cold.

A US recession will be the result of the bubbles and excesses of the US economy in the last few years: a housing bubble now going bust; negative household savings; negative government savings (i.e. large budget deficits), low national savings and thus a large current account deficit. The party will be soon over; and the complacency and under-pricing of risk in financial markets will soon be corrected with painful consequences for the US and the global economy. The US economy has been living in a financial bubble for too long. Now this bubble is bursting – yesterday in housing and sub-prime, today in the stock market, soon enough in a wide range of other risky assets. The fallout will be very painful for the US and the world once a US recession and severe financial sector distress interact in a vicious cycle.

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