Europe Faces Day of Reckoning in Emerging Market Debt

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You know it’s a real financial crisis when capitalists are being told what to do by a bunch of socialists and communists. But these are the times we live in. Ironic and moronic.

Investors will be utterly confused today about what to fear most. First, you had the nightmare open in New York on Friday. The futures markets were limit down and closed briefly. By the time order was restored to electronic markets, the Dow opened down 6%.

The Dow rallied-if you can call it that-to close down “just” 3.6% on the day. A that point, you could safely say the market was ‘pricing in’ the fear of a global recession, and just what that would mean for corporate earnings. Not even an oil price of US$65-meaning lower prices at the pump-could cheer investors.

And then, this weekend, European and Asian leaders met and, “pledged to undertake effective and comprehensive reform of the international monetary and financial systems,” according to Bloomberg. China’s Premier summed up the argument for the 40 heads of state present by saying, “we need even more financial regulation to ensure financial safety.”

And thus a great debate unfolds in the weeks ahead of the November 15th G20 summit in Washington. Was the crisis a result of unregulated “cowboy capitalism”? Or did it have its roots in phony, government-regulated interest rates, which skewed corporate and personal incentives in favour of debt-based speculation? More that in a moment.

Did you see news reports that the RBA intervened in the currency markets? The Bank is trying to prevent the Aussie dollar from going “splat!” Truly, there are few currencies in the world that have fallen so much, so quickly. But why?

Chatting with Swarm Trader Gabriel Andre this morning, he said the seven-year up-trend in the Aussie-Yen currency pair has been completely reversed in the last three months. Kris Sayce will be running Gabriel’s comments in today’s Money Morning. What does it mean?

The currency pair is as good a symbol as any for what fuelled the global rise in speculation. You could borrow virtually for free in yen and invest in high-yielding currencies and assets. Those assets included Aussie stocks and the Aussie currency itself. The collapse of the yen and dollar carry trades is what’s behind the plummeting Aussie dollar.

Meanwhile, the government still hasn’t fixed the problem that’s mushrooming in the cash and mortgage fund market. Over $11 billion is still frozen in those accounts as the firms that run them try to work out a deal with the government. But what deal could there really be?

Investments in mortgage funds are not deposits in banks. By guaranteeing bank deposits, the government drew attention to the fact that investments always have risks, and that some risks cannot be insured against. You either take them and accept the risk (in exchange for the return), or you keep your cash in a safer, but lower-yielding security (or in cash, subject to inflation).

It would be nice if you could get a guarantee in life that you’d never lose money no matter what kind of decision you made. But no such guarantee exists. It just happens that we live in an age where no one expects to lose at anything, ever. This goes for kid’s soccer games as well as financial markets. But if there aren’t real winners and losers, you don’t have a real market.

Congratulations to our friends at www.businessspectator.com.au. The financial news and analysis site is turning one year old this week. It’s a precocious one-year old, though. And there is a lot of collected wisdom there.

For instance, Robert Gottliebsen recently made this chilling observation about the hedge fund meltdown, “The mortgage fund freeze has escalated the number of superannuation investors who are demanding to exit the managed fund equity system. At the moment it is containable but if the move to quit shares balloons we will see big forced selling of Australian stocks.”

Hopefully the mortgage freeze will end soon. Perpetual says this morning that it would like to end its freeze on redemptions as soon as possible. Exactly when that is is anybody’s guess.

As if the credit crunch and a global recession weren’t bad enough, investor now have to deal with calls by the Europeans and Asians for Bretton Woods two. Everyone wants a new global financial system. But it’s not like buying a new shower head or toilet seat, is it? You can’t just run down to the shops and get one, along with some beef jerky.

It’s obvious the current system is breaking down. Globalisation-made possible by cheap money and cheap energy-is contracting. You know for certain that governments, being blame artists, will blame markets. But it’s not the market’s fault. As with every bubble, from Tulips to the South Seas to the Mississippi Scheme, it’s people who pervert markets.

Sure, CEOs and corporations turned normal businesses into vehicles for private speculation. But that is a failure of management, not the market. More oversight by corporate boards and shareholders might have made for better discipline in risk taking. But discipline is exactly what people lose in a bubble.

The credit bubble was remarkable because it leveraged the interconnectedness of global markets, allowing investors to borrow in weak currencies and invest in high-risk, high-yield assets. It wasn’t a regional or even national bubble. It was the whole planet.

But in its other essential features, it is indistinguishable from previous bubbles, manias, panics, and crashes. One of those features in fact, is how governments and bad regulations actually enlarge, prolong, and generally abet the bubble. And in this one, because everyone had a stake in its expansion, everyone has tried to keep it going. The best example of this is the determined allegiance to the dollar-pegged world financial system.

The price of money is fixed by central banks via interest rates. For years, everyone followed the Fed’s lead in the U.S. and set the price of money below rate of consumer price inflation. Australian mined. China produced. Europe traded. OPEC pumped. The U.S. spent.

Global bubbles in all asset classes ensued. That is a failure of the highest order by the regulators of global interest rates. Now politicians see massive wealth destruction and blame free markets for screwing things up when it was the non-market price of money that touched off the crisis to begin with.

In any event, we’re going to get some sort of hogwash in the next month from the confab in DC. There will be more supervision of banks. It will probably lead to less bank lending and tighter credit. Hedge funds will be regulated. Many investors will anticipate this by taking their money out ahead of time. Redemptions will force more asset sales. Stocks will fall.

The International Monetary Fund will probably enjoy some enhanced status. The IMF is already bailing out a bankrupt Iceland. It will loan US$16.5 billion to Ukraine. Before it’s all over, we reckon Japan and China might even consent to loaning some of their huge dollar reserves to the IMF in exchange…for something.

We’re not sure what it would be yet. The IMF may become a super-bank with access to funding from central banks, a kind of supra-sovereign wealth fund in the service of a world government and regulation. That sounds…not encouraging.

Also, keep in mind that the entire strain of the crisis in the U.S. was generated by a politically desirable outcome in residential housing. The original mis-allocation of investment dollars came about because politicians insisted that banks make loans to people who couldn’t repay them. Market discipline was actively subverted by political opportunism.

The U.S. set up Fannie Mae and Freddie Mac with preferential borrowing terms so those two could buy up mortgages originated by the banks. The banks could sell the mortgages quickly, which put them in the position to fund even more mortgages and expand “home ownership” in America.

We all know how that’s working out. Median U.S. house prices continue to fall. The loans made to finance those homes are going bad. The securities made up of bundles of those mortgages are rotting, taking bank capital with them. And insurance sold against default in them is putting the sellers of that insurance into great difficulty.

Europe, for its part, has a brewing problem in emerging market debt. Austrian banks are exposed to sovereign emerging market debt to the tune of 85% of GDP. Swiss banks have emerging market debt equivalent to 50% of GDP. It’s 25% in Sweden, 25% in the U.K., and 23% in Spain. If more emerging markets go the way of Iceland and default on debt or go bankrupt, Europe’s banking system faces major trouble. Just what we needed. More trouble.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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9 Comments on "Europe Faces Day of Reckoning in Emerging Market Debt"

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Ian Lucas
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“…the entire strain of the crisis in the U.S. was generated by a politically desirable outcome in residential housing. The original mis-allocation of investment dollars came about because politicians insisted that banks make loans to people who couldn’t repay them.”

Simple as that, huh?

I hope your investment advice is more nuanced.

Coffee Addict
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I am starting to feel BULLISH! The value of the Australian Market has dropped around 60 to 65% when valued in the USD or the EURO. Its all been oversold even “bearing” in mind the inevitability of a major global recession. The key advantage to Australia is the sell off of the dollar – which means that Australians can continue to be competitive within a very gloomy, shape shifted global market. There will be no V curve rebound. This time it will be a long an L curve so there is no reason to jump into the market quickly. It… Read more »
Greg Atkinson
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Coffee Addict,I was using Yen to buy Australian dollars yesterday, not serious money just a nibble,but I know the Japanese cannot afford to have the Yen this strong, so something will go “snap” eventually. There are also a lot of Australian companies that will get a big balance sheet boost from a weak $AUD and so it is not all gloom and doom. I am also hoping some of the ASX listed Japan Property Trusts get a boost since in theory their portfolio is now up around 40% in dollar terms. (although the property market in Japan is a little… Read more »
Martha
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I am going to Japan in end of Nov. The Australian dollar has drop so much compare to Japanese Yen. Everything now cost 50% more expensive. I am kicking myself for not changing the dollar when it wasn’t too back at around the 1-80 mark. Now is only 1-55. Can someone help me and give me some advise? Should I wait for a little longer? and change when I get there? Or should I change whatever I have now save up for the last 6 months on this trip…….which is becoming nothing….. I am so so scare that I can’t… Read more »
Tony
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The Rothschild and Rocketfella are desperately pushing the New World Order. They want to brought us to its knees and beg for a new currency and and new system. Amero and World Central Bank. And finially One World government.

It is not because of the people who are evil, But because of the good people who don’t do anything about it -Albert Einstein

watcher7
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1974-76 rally = 2008-10 rally? The 1974-76 Dow Jones Industrial Average rally of 75.7%, that began in the recession of 73-75, a ‘type’ for a future rally, beginning in a recession? The Dow valuation high of 1966 = 2000; or alternatively The Dow and ‘glamour’ stock high of 1968 = The Dow and ‘dotcom’ stock high of 2000 – Presidential election years. Valuation highs in Democratic administration second-terms in 1966 and 2000. Mild recessions in Republican administration first terms in 1969/70 and 2001. Nominal Dow highs in Republican administration second-terms in 1973 and 2007. The 1966 (1968) decline of 36%… Read more »
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