When you grow by credit you die by credit...

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A slowdowm in credit has wrecked havoc and the contagion seems to be widespread

I have focused in this report more on the technical than the fundamental side of analysis. But, I explained the problems in the CDO market in depth in the July report. Also, in the past I have emphasized that in a credit driven economy a slowdown in credit growth wrecks havoc in asset markets and the economy. In the US, growth in credit began to slow down for the household sector in 2006 and has now spread – to the total surprise of the goldilocks crowd – to the financial sector. It is not the Fed that has tightened monetary conditions but the market as a result of losses in the credit market. Suddenly the availability of credit has diminished, which under normal conditions should stabilize and even strengthen the US dollar, and as explained in last month’s report, the Japanese Yen. As of mid-July sentiment for the US dollar was extremely negative and, therefore, a more meaningful US dollar low is possible.

Still, to go long the US dollar is a relatively low confidence bet, as we should expect on further stock market weakness the Fed to cut interest rates. Also, it would be wrong to think that the problems in the US credit market will be isolated and not impact asset markets outside the US. Tighter lending standards and higher borrowing costs in the US (as a result of spreads widening) will spread to other markets around the world. And since foreign markets outperformed the US since 2003 by such a wide margin some hefty corrections/crashes should be expected there as well. On a recent trip to the US it came to my attention that a very large number of family offices and pension funds, which before hardly ever owned emerging and other foreign market equities, suddenly had up to 50% of their money overseas. Assets in emerging market funds have more than trebled since 2003. The enthusiasm for foreign markets is certainly reason for some concern!

There is no doubt that from time to time stock markets will rebound sharply. However, given the high probability of the US economy moving shortly into recession (if inflation was properly measured the economy would already be in stagflation) and with an increasing number of companies reporting disappointing earnings (cost pressure leading to a margin squeeze) I would be inclined to reduce positions on rebounds. This time the decline could be far more severe than what we saw in the second half of 2005, in May/June 2006, and in February/March of this year. Moreover, as explained above, new stock market highs are unlikely for the rest of the year. I am however, doubtful that the “Supercycle” will turn down to where Robert Prechter thinks it will decline to. On any further market weakness the Fed and the Treasury will come up with some hyper-inflating tricks.

In June, we recommended the purchase of Two Year treasury notes. The yields having declined from over 5% to around 4.5% makes these notes less interesting.

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Source : IIPM Editorial, 2007

An IIPM and Professor Arindam Chaudhuri (Renowned Management Guru and Economist) Initiative

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