SPECIAL SECTION: The Threat of Dubai Debt Crisis Spreading Hangs Over All Global Asset Markets
Key Points to Note
The 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
a far more dramatic response from the dollar and nearly every other asset class is quite conceivable, thank you.
Market concerns include:
- Rising risk aversion lowers 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 note 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 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, which brings them closer to defaults of their own.
- More borrowing to solve the Dubai crisis makes another one more likely.
o 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.
o 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.
Ray Of Hope From Friday's End of Session Action?
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 Consider
As 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.
Investors fear that this could mean an outright default on Nakheel's debt, because delinquency is usually the precursor default.
While U.S. and European banks have very small exposure to Nakheel’s debt, it's not fully clear who has what exposure, and how well they can absorb possible losses. Many believe the crisis is quite containable
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?
Analysis: 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.
Black Friday Results Due Early This Week
In addition to the reverberations from Dubai, another critical event played out on Friday- Black Friday, named because it's the official opening of the US holiday gift buying season that essentially extends until after the New Year. Results should be out early this week and give some hint at how this make-or-break period for retailers plays out. A bad season could mean more layoffs and commercial loan defaults from the retail sector.
Weekly Recap Nov. 23-7
A surprising sell-off in overseas markets triggered by Dubai debt concerns led to sharp losses in U.S. equity markets on Friday, wiping out the gains made earlier in the week.
The market's only notable move higher this week came at the open on Monday, when a weaker U.S. dollar and much better-than-expected Existing Home Sales report helped stocks surge.
Stocks held those gains through Monday's session, and into Tuesday and Wednesday as volume slowed ahead of the Thanksgiving Day holiday. But one headline from Wednesday, that the UAE government was restructuring Dubai World, didn't initially receive much of a reaction.
But on Thursday, with U.S. markets closed, European markets plunged as concerns grew, helping to change investors' risk appetite. The Dubai government asked creditors, which reportedly include many European banks, particularly in the United Kingdom, to defer payments on some $20 billion in debt coming due over the next 18 months.
Asian markets, which had traded lower on Thursday, plunged overnight on Friday, and the weakness carried over to U.S. markets, with the S&P 500 losing 1.7%.
Even if Dubai crisis is contained, it may still serve as warning for those seeking to book profits ahead of yearend tax selling to do so soon.
Commodities dropped sharply around the world along with risk sentiment from fear of contagion effect from Dubai debt payment delay request, which could trigger second wave in the credit crisis. Gold has a better chance of stabilizing and recovering if Dubai crisis is contained, because it has shown it can rise while the other markets struggle. Oil to follow stocks, then fundamentals. Both of these bearish for now.
On Temporary "Dubai High" or Reversing Trend?
US Dollar Outlook: Bullish
- Key Events: Monday: Preliminary Black Friday Sales Results, Tuesday ISM Manufacturing PMI, Pending Home Sales m/m, Construction Spending m/m, Wed. Fed Beige Book, Thurs. ISM Non-Mfg. PMI, Fri. Non-Farms Payrolls, Unemployment Rate
- Fear of Dubai debt default contagion reminds traders of the dollar’s value
- US recovery more measured than initially expected, confidence uncertain
- Is the USD's recent bounce the start of a true technical reversal?
Critical ECB Decision, US NFP Bring EUR Volatility -Euro Drops on Dubai World Credit Scare
EUR Outlook: Bearish/Neutral – Moving Opposite USD
- Key Events: Mon. Eurozone (EZ)CPI y/y, Tues. German Unemployment Change, Rate, EZ Unemployment Rate, Wed. EZ PPI m/m, Thurs. EZ GDP q/q, Retail Sales m/m, ECB Interest Rates
- Bargain-hunters still maintain Euro bid through week’s end, suggest EUR resilience or USD weakness in the face of all but most dire crises, suggesting EUR/USD downtrend tough to break barring real pullback in stocks.
- ECB Decision to reduce QE could boost EUR, but could be outweighed by big moves in stocks
- EURUSD double top still forming?
Diminishing Risk Appetite To Support the Pound?
GBP Outlook: Bearish
- Key Events: Sun. Gfk Consumer Confidence, Hometrack Housing m/m Mon. Net Consumer Credit, Mtg Approvals, Tues. Nationwide House Prices, PMI Mfg., Thurs. PMI Services
- The second reading of U.K. 3Q GDP was revised higher to 0.3% from 0.4%, as Private consumption improved, but still shows UK in recession
- The BBA reported that loans for house purchase rose to 42,238 from 42,073, highest in over a year
- The CBI Quarterly Distributive trades reading improved to 13 from 8
- Lies in the middle of risk appetite spectrum, will move with risk appetite, USD
Probable Drop In Risk Appetite & Improving Fundamentals Likely to Outweigh BoJ Intervention Threats
Yen Outlook: Bullish
- Key Events: Mfg. PMI, Industrial Production y/y, Mon. Housing Starts, BoJ. Gov. Speaks
- Trade Surplus Swells as Unemployment Weighs on Imports
- BOJ May Resume Buying Corporate Debt, Meeting Minutes Show, to weaken the yen
- Jobless Rate Declines For the Third Month as Workers Exit Labor Force
- Officials Step Up Currency Intervention Threats as Yen Pushes Higher
- The key to restoring yen weakness lies with stabilizing risk appetite than with the BoJ
- BoJ should consider US examples of how to weaken a currency via stimulus increase
Moving With Risk Appetite, And That's Good For the CHF
CHF Outlook: Bullish/Neutral
- Key Events: Mon. SNB Chairman Roth Speaks, Tues. SVME PMI, Friday CPI m/m
- Safe Haven Status Helps in Dubai Scare
- SNB intervention looms if big pullback in risk assets pushes CHF higher against the EUR
- Gaining against USD, EUR
CURRENT ACCOUNT DEFICIT HITS RECORD HIGH-Likely to Continue Following Oil, Stocks, News In That Order.
CAD Outlook: Bearish
- Key Events: Mon. GDP m/m, Fri. Unemployment Change, Rate, Ivey PMI
- Losing ground to the USD since mid October, trend could continue
Riding Risk Appetite Down, But Could Be Least Hurt Of All The Risk Currencies
AUD Outlook: Bearish
- Key Events: Tues. Building Approvals, Cash Rate, RBA st., Thurs. Retail Sales m/m
- Moving with Risk Appetite, But May Drop Least if Markets Pull Back
Moving With Risk Appetite And Thus Vulnerable to Pullback
NZD Outlook: Bearish
- Key Events: Mon. Building Consent
- Like the CAD, has risen with the AUD yet lacks the fundamentals to justify the rise
- Little major NZD news means it will go with risk appetite, which is likely to be flat to down
- Down trending against the USD since early Nov
The beginning of the week will be dominated by further reactions and news related to Dubai, we expect some attempts to calm markets from Dubai and other world leaders. Black Friday results may also figure strongly. After that ECB announcements about reducing QE and events leading up to and including US employment reports Friday should be the dominant market movers.
Traders should keep watch on these events and as always, on the major stock indices, especially the S&P 500.
DISCLOSURE – NO POSITIONS IN ABOVE MENTIONED INSTRUMENTS