Key Points to NoteThe biggest near term influence on the direction of risk appetite and global markets appears likely to be the Dubai debt crisis, so we need to evaluate the importance of this past week’s credit scare.
The request to delay repayment on its loans by Nakheel (a real estate development arm of Dubai's development fund Dubai World) confronts markets with what is potentially the largest sovereign default since the 2001/2002 when Argentina stopped payments on its government bonds. The Dubai default threat does not have the same fundamental complexities as its Argentina's did, however, context and timing can be everything.
Given that markets are:
- Sitting atop an extended rally on questionable fundamentals and valuations
- Nervously remembering how two years ago, a supposedly containable US real estate default crisis metastasized into a near worldwide financial and economic collapse from which they are still trying to recover
Market concerns include:
- There could be “contagion”-type effects that could affect the creditworthiness of related entities, particularly those that have lent to Dubai World. Most of those are either UAE-related or European banks. This isn’t a huge issue, unless it becomes a big European issue — unlikely, but remember that European banks are even more levered than US banks. It's believed that UK's RBS, HSBC, Barclays, Lloyds and Stand Chartered are having large exposures in case of defaults. Who would be affected if these were undermined?
- Secondary aftershocks to would be entities similar to Dubai — other places in the world that have borrowed a lot (Greece, Ireland, Iceland, parts of Eastern Europe, etc). Thus many emerging markets are getting hit in this mini-crisis by rising borrowing costs.
- More borrowing to solve the Dubai crisis makes another one more likely.
- What investors should remember is that in ordinary circumstances (peace, absence of famine, plague, or rampant socialism), the economies tend to grow at about 2%/year. One can try to increase that by borrowing, and at the right opportunity that can be a winner. But most of the time, huge increases in debt levels are eventually associated with default. In a highly leveraged financial system where lenders are themselves indebted, defaults can cascade. As markets get more risk averse and credit tightens (i.e. rates rise to compensate for perceived increased risk) various government ministers/bureaucrats come forth and say, “There is nothing fundamentally wrong here. All we need is to restore confidence. This is not a solvency issue, it is a liquidity issue!” They answer by taking on more debt to free up liquidity.
- Risk that an isolated default can spread then rises, as an increasingly leveraged financial system comes more and more to resemble a massive arrangement of dominoes. The more leverage on any entity, the taller that domino. The more leverage in the system, the more tightly the dominoes are spaced. That arrangement collapses when someone knocks over a key domino.
In the week ahead, the key to gauging price action for the broader financial markets and the USD will lie with the market’s ultimate response to the Dubai crisis. There hasn't been enough time to see market’s true response to the threat. The incredible volatility through the end of last week was certainly leveraged by the thin liquidity from the US holiday.
Indeed, the timing of Dubai World's announcement coincidentally (?) allowed an incredible short term profit opportunity for anyone with advanced notice, and to minimize the time markets had for panicking before taking a weekend break to calm down and perhaps minimize the chances of an even more extreme reaction. Liquidity was extremely low at the time of the Nov 25th-26th announcement, with both the US and Islamic World their respective Thanksgiving and Eid holidays. Thus the volatility generated by this market moving news was exaggerated by the small number of traders available.
The demand for safe-haven dollar shorts unwound was so strong that the euro hit an intraday low of 1.4829 when the European markets opened. The price action in USD/JPY tells us that risk aversion was the primary driver of the forex markets as USD/JPY dropped to a 14 year low when the Asian markets opened last night.
Perhaps very significantly for the coming week, the selling did not continue into the U.S. trading session. The limited number of U.S. traders Friday actually sold rather than bought dollars which suggests that not everyone believes that the Dubai news will have immediate global ramifications, because the first reaction to a major surprise announcement like this one is always sell first and ask questions later. As a result, the USD and JPY were the biggest winners. That USD buying didn't continue into Friday suggests markets might open Monday on a more positive note.
Indeed, when the deep pockets return to the market after having had a weekend evaluate things, it will be easier to establish true trends as there will be a source for momentum.
While we can't say for certain whether this is the beginning of a longer term reversal in risk assets, some tentative conclusions can be drawn.
Additional Points to ConsiderAs noted above, a major surprise risk event like the Dubai news is one of the few things that might set a near term bottom in the U.S. dollar as its safe haven status overrides its still poor fundamentals. On the eve of November 25th, the Thanksgiving Holiday in the U.S. and the Eid Holiday in the Middle East, Dubai World shocked the markets by saying that its property developer Nakheel has requested to delay its Dec 14 debt payments. While Dubai World is not technically owned by the Dubai government, its liabilities of US$59 billion is a significant amount of the total estimated US$80-100 billion in Dubai's liabilities.
As a result, investors fear that this could mean an outright default on Nakheel's debt, because delinquency is usually the precursor default. Although the market believes that this is a major development for the global economy, it is important to realize that Nakheel's debt is only $3.52 billion, a fraction of Dubai World's overall debt. Also, U.S. and European banks have very small exposure to Nakheel’s debt, though it's not fully clear who has what exposure, and how well they can absorb possible losses.
However, markets heard the same kind of talk at the start of the US sub-prime lending crisis, and realize that these things can quickly snowball into far bigger problems.
Granted a default may entitle investors to some of Dubai World's assets, H.H Sheikh Ahmed bin Saeed Al-Maktoum, Chairman of the Supreme Fiscal Committee, has already issued a statement confirming the Dubai Government's intention to directly intervene and manage the restructuring of Dubai World commercial operations and its debt obligations. Although some people are afraid that this could turn into an Argentina style debt default or a repeat of volatility of Q4 2008, what is more worrisome is the fact that this may be indicative of the health of the entire property sector in the Middle East. Which global banks are deeply exposed there?
STOCKSAnalysis: Apart From Dubai, Pullback Potential Was Already Present & Watch for Black Friday Results
Even before Dubai threatened markets with the largest sovereign credit default since Argentina in 2001, a larger underlying shift in global capital markets likely already began in October. In addition to Dubai, consider the already extant pressures on risk appetite.
- Morgan Stanley index of world stock prices fell the most in eight months while
- The VIX Index, a stand-by measure of investors’ fear, rose the most in a year.
- The S&P 500 remains unable to sustain a break above multi-week resistance at 1100, and any failure by world leaders to calm markets soon will harden that resistance.
- The financial system's resistance to further crises has been weakened by the crisis of the past two years, with central banks already burdened with debt. Relative equity valuations have looked excessive for some time now with prices trading at the highest levels relative to earnings in seven years.
- Further, the market’s mood seems to be in transition, with the relief that collapse had been averted, which produced the risk rally of recent months, giving way to concerns about valuations and what happens when interest rates invariably reverse course higher and the flow of government cash dries up.
- Companies’ “better than expected” earnings of the past several quarters have relied heavily on, cost cuts, usually from firing workers. Ultimately this means lost consumer demand.
CommoditiesIf the crisis appears to spread (and this could take time to play out, similar to the US subprime crisis), most will drop back. This includes gold, unless fear of another threatened global collapse occurs, which could favor gold.
CurrenciesIf the crisis lingers on, or markets pull back for some other reason (there are potentially many), the JPY, USD, and CHF will be the big likely winners. The AUD, NZD, CAD, and EUR would retreat against these.
DISCLOSURE: NO POSITIONS IN THE ABOVE