Dominoes

The dominoes have started falling...

I don't expect them to be contained.

One of the amazing things to me is that after a ton of failures last year (AIG, Lehman, Citigroup, Merrill, Bear, Bank of America, Fannie, Freddie, GM, Ford etc..) and international disasters (Iceland), since March 2009, things have been very calm.

Until Thanksgiving weekend, when Dubai World basically announced a default prior to a four day Eid holiday.

Dubai World is technically not a sovereign, but basically the equivalent of a crown corporation of its government. The government of Dubai has stated that it will not bail out Dubai World. However, most reports have it holding the majority of Dubai's debt ($60 billion minimum of roughly $100 billion for the whole country- who really knows the true numbers?). Basically, a drop in the bucket in the grand scheme of things, but a possible domino in the interlinked global financial system. Losses in one asset class can lead to selling in other asset classes as leveraged investors sell good assets to pay for the losses, particularly in the case of those banks stuck with Dubai World paper.

My knee jerk reaction to Dubai (sorry, didn't get time to publish it) was that it would cause a short term sell-off until the "it's contained" bulls came out and bought. My thesis was that it would at temper the USD carry trade into risky assets by making people at least question default risk, especially in countries where the rule of law isn't quite as strong as in democratic countries. The market would then relax a little as long as the Dubai story stay contained.

And relax it did (much faster than I thought), and the USD completely reversed the flight to quality from Dubai. The S&P hit a new intraday high last Friday.

This week, Greece has been in the spotlight as it is basically running up too much debt after lying its way into the EU. Greece is another domino. Bigger than Italy, Portugal and Spain. The market now is pricing in a possible Greek default. It has a higher credit risk than Columbia or Panama. It is part of the Euro, so it can not devalue or cut rates to get out of its problems. Greece has to refinance or issue 47 billion Euros in 2010. Good luck with that! My guess is that the EU will force Greece to make massive cuts to its spending and increase taxes before even contemplating any bailout. The EU is reluctant to bail out Greece (and it has no official duty to do so) because it would create a moral hazard and the list for bail out candidates is very long.

Here is a list of other potential trouble spots:

1) Latvia is a small country, but it is on the edge of a devaluation of its Euro peg. Devaluation could spread to other Baltic and Eastern European countries, which have mindboggling debt loads. Where does most of the debt reside? European banks
2) Eastern Europe is a big mess. In the boom, credit was flowing to these countries (again European banks). Housing bubbles, euro mortgages for countries that don’t use the Euro, huge deficits. Ukraine may default and has a crucial election coming up in early 2010.
3) Spain has a bigger housing bubble than the US. It has likely yet experienced the worst of the implosion. Add Portugal and Italy to the list of suspects as well.
4) Ireland, the former Celtic Tiger, is in bad shape. It appears to be taking its medicine but you never know about aftershocks.
5) Dubai and the Middle East: Dubai has technically not defaulted, but realistically it has. It is the posterchild for debt excesses. If it can get bailout money from Abu Dhabi, maybe it can muddle through somehow. And all of this is with $75 oil. Imagine what happens if oil goes to $20!
6)Venezuela and Argentina are also possible trouble spots. According to the CDS market, they have a high chance of default.

Longer term dominoes:

1) China: I am not a believer in the China story. China’s economy is supported by exports and fixed investment. Exports are getting killed, obviously. However, consumer stimulus and fixed investment has more than picked up the slack. There is an investment bubble of epic proportions. Fixed investment is up 50% (!!!) over already inflated levels. Banks are lending with no realistic chance at a decent return. I see a lost decade coming for China at some point. With a rapidly aging population, China is rapidly becoming yesterday’s story and not tomorrow’s as 99.9% of the mainstream media would have you believe.
2) Japan has almost 200% government debt to GDP and is locked in the throes of severe deflation. It has been saved by rock bottom interest rates. If the market ever gets scared that Japan will not be able to pay its debt, interest rates would soar, making Japan’s debt load completely unaffordable. Japan has a ton of domestic savings, you say? Yes, it does, and that has saved it thus far. However, savings are dropping to near zero as its population ages while debt grows exponentially. This is a longer term domino but worth keeping in mind.

3) UK is in bad shape right now. If you get another financial crisis like 2008, good luck!
4) In the US, there is a huge reset in Alt-A and Option-ARM mortgages that is JUST STARTING. Combined with 10% unemployment, I expect foreclosures and defaults to soar in 2010, and house prices to continue to fall. Commerical real estate is a big mess. Budget deficits and growing intolerance for any new bank bailouts are going to make 2010 challenging for the bailout kings if things unravel once again.

Most of these dominos involve the same story. Too much debt, not enough savings.

What does this mean for 2010?

I have been looking for trouble abroad to be the next catalyst. I have laughed at those who have blamed the Americans for all of the world's problems. I even heard one analyst in Dubai blaming the US as the originator of the world financial crisis that has now washed up on its shores. Gimme a break! Dubai has built up a fantasyland in the desert with excess leverage. It was bound to fail eventually.

These dominos are likely to strengthen the US dollar especially versus the Euro, and tank commodity prices and stock prices as we go forward from here. I expect many sovereign defaults in 2010/2011 in addition to big problems with provincial and state debt loads in Canada and the US.

I am not sure how it plays out but I suspect that credit spreads are going to widen for most countries and it could even infect the safer credits of Japan, the UK, Germany and the US. The Dubai and Greece experience are going to make many bond investors look at the details of what they are holding (not sure why the experiences of 2007/08 didn't do that, but I digress). In addition, credit losses on defaults are going to hit, what else, the financial sector, with unknown further dominoes, including derivatives and/or bank runs.

In recent days, the US dollar has strengthened due to this return to risk aversion (and a strong employment report on Friday). The US dollar is the most hated asset class and everyone thinks it is going down. I think the dominoes are likely to send the Euro down to par over the next few years, and the US dollar is likely to be very strong in 2010 (target 1.15 to 1.25). This will unwind the carry trade with a steep drop for stocks and commodities. In addition, stocks are overvalued so a move to new lows in 2010 is very likely.

This does not even factor in the effect that an Israeli attack on Iran would have. That has a much higher chance of happening in 2010 than most are contemplating, I believe. (I will need to cover this in further detail at some point).

I suspect that with only a handful of trading days left in 2009, the bulls will keep things afloat for year end bonuses. Perhaps a move to new highs in January even. I fear that 2010 is looking to be a repeat of 2008.

Meanwhile, the useless mainstream economists (not Rosenberg or Krugman) will tell you that it is going to be a slow but steady recovery with GDP growth in 2010 & 2011 of 2 to 3%. When the catalysts hit, they will say "no one predicted X, no one could have seen Y" as their models can't cope.