Markets Melting, More to Come

In late May, when the S&P 500 was trading just shy of its “post-crisis” highs, I made the case for why we should expect more pain … a lot of it. And I said, with QE2 ending in June, QE3 may follow.

Today, I revisit some of that big-picture analysis.

In the past several weeks, we’ve seen clear evidence that global economies are falling back toward recession territory, if they’re not already there. And the global sovereign debt crisis continues to grow in severity.

With the United States in the crosshairs of a potential downgrade, the contagion in Europe has spread to Italy and Spain — two countries that are too big for EU and IMF officials to convince global markets that a magical backstop can be crafted.

Now, just at the time when most economists predicted leading central banks would be aggressively hiking interest rates to normalize policy, some are easing further. And other central banks that have been in hiking mode will likely reverse course, making big cuts.

For the Fed, that puts QE3 back on the table. But that’s not going to happen before price pressures subside and begin threatening deflation again.

And that is likely. Here’s why:

The Delusional Recovery

While the evidence of this type of unraveling has been right under our noses throughout this global economic crisis, most experts, market practitioners and politicians have done their best to ignore it.

It takes a plunging U.S. stock market for most to recognize that the “recovery” was delusional. As I’ve outlined many times here in Money and Markets, the most thorough analysis of global financial crisis was done by Carmen Reinhart and Kenneth Rogoff. Though many ignored it, they revealed in 2008 the expected fallout from this crisis in 2008.

Their study showed that global financial crises typically lead to sovereign debt crisis. Sovereign debt crises typically follow a progression of rising deficits, rising debt, an onslaught of downgrades and finally defaults.

And their study showed that the 10-year global credit buildup would likely take as long to unwind (10 years).

So the deleveraging process tends to take around a decade. And for the extent of the deleveraging period, the study suggests:

  Economic growth trends at lower levels than pre-crisis growth,

  Unemployment hovers around 5 percent higher than pre-crisis levels,

  And housing prices remain anywhere from 20 percent to 50 percent below peak levels.

This has been nothing less than the script for the way economies have been behaving, particularly in the United States. If you mark the meltdown in subprime mortgages in early 2007 as the beginning of the global economic crisis, then we stand at about four years in.

Here’s how those three areas I’ve just mentioned are doing:

  Recent economic growth in the United States for the first half is running at less than three-quarters of one percent annualized. That’s after record fiscal and monetary stimulus.

Source: St. Louis Fed

  Unemployment remains above 9 percent. And the nine months of job gains are heading back toward job losses — again.

Source: St. Louis Fed

  And home prices fell to a new low in March, and remain 32 percent off of the 2006 highs, despite all of the failed government rescue programs.

Source: Case-Shiller

Given this backdrop, global financial markets have a long way to adjust — from pricing in recovery, to pricing in the reality of ongoing crisis and economic shocks.

Economic Health Sirens
Scream Downturn

Two leading proxies of global economic health gave clear signals this week of another downturn in financial markets.

Below is the chart of the S&P 500:

You can see the index broke the key trendline (in blue) this week that represented the bull trend in stocks that has taken place since early 2009. This opens up technical downside targets of 1,100 … then 1,020 … and then the big retracement level in the 940 area.

In crude oil, the chart looks very similar:

Crude oil was said to be the proxy for global demand — especially attributed to the evolving emerging market economies. But when speculators got wind of an impending hike in margin rates in the second quarter, it was exposed as a market full of speculators.

Now the break-down of this long-term trendline (the blue line) opens it up to another big decline — if the world continues to unravel at its recent pace.

And the above two charts paint a gloomy story for one of the highest performing currencies in the world over the past three years, the Australian dollar.

In the above chart, you can see the dive that the Australian dollar took in the first round of financial crisis, falling 39 percent in just five months. Perhaps the most vulnerable to global risk aversion, the Aussie dollar is now breaking a long-term trendline of its own.

Moreover, while rising interest rates were the key driver behind its strength in recent years, a major Australian bank is now expecting 1.25 percent rate cuts out of Australia through next year. That’s in sharp contrast to what was expected coming into 2011.

The Bottom Line for Investors

Many think the world is looking like a scary place again. The fact is, the world economy has been a scary place for four years. And all of the evidence points to a continuation.

We should always seek out investment returns that compensate for risks taken. In this environment, which is highly vulnerable to economic shocks, not many exist.

That’s why I continue to think we’ll see another aggressive flight of global capital back to the United States — home of the deepest capital markets and most liquid currency. In crises, capital preservation is king.

Regards,

Bryan

P.S. To learn how I’m helping my World Currency Trader members position themselves during this global unrest, click here.