A Double Whammy?

There is a huge difference between a market in decline and a collapsing market. As oil crashes from $115 to $60 bucks (Brent crude) over a short period of time, it would be a fair assessment to say that this market has disintegrated to the "collapsed" category. The "double whammy" might just be that another large crisis is lurking in the shadows getting ready to reveal itself. The rise in the US dollar has far reaching consequences and will arguably compound other crises, probably on a larger scale than the oil rout.

But I am getting ahead of myself. Back to oil and the collapse of this commodity. Some say that when political leaders abuse the market place, these markets take over and create honest souls out them. Too little, too late. Glancing back a few years, the  US relied on some of its energy from foreign sources. Then the discovery of new methods of oil extraction (fracking) increased US oil production to the point where the foreign energy producers had to find new and developing markets for their product. This in turn led to an economic war for market share. Oversupply and market share antagonism has brought us to this point in time.

A knee jerk reaction to the fall in oil prices is one of satisfaction. Cheaper oil means cheaper gas prices, lower expenses and more to spend. So why the commotion in the capital markets? Think 2008 and the collapse in real estate prices and what followed. If oil prices had taken a year or more to decline, the markets would have had time to adjust. The suddenness of this reversal in primary trend took most markets by surprise. Energy producing countries find their budgets under extreme pressure as income evaporates. Many consumers have signed long term contracts at what are now exorbitant prices. A large part of world energy infrastructure finds itself with nowhere to turn.

Two decades ago emerging markets (china, India and others) accounted for about 20% of world GDP. Today these markets account for about 50% of world GDP. A very different story. A slowdown in these markets will have a definite effect on world GDP, especially since average growth in Europe and Japan is close to zero. With inflation rates close to zero, the fall in energy prices brings many countries terrifyingly close to deflation. With negative inflation, interest rates become very real. And this brings us to the mighty US dollar.

The USD continues to be the world's accepted reserve currency. Most international deals are made in the US currency and it accounts for one side of 87% of all international trades. The Bank for International Settlements just released its quarterly review, with an urgent warning: "The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on EMEs [emerging-market economies]". Remembering that emerging markets now account for 50% of world GDP, lets take a look at a small academic example and then multiply by zillions.

Its the year 2008. The US economy is in tatters. Interest rates drop close to zero. The USD is out of fashion. A small company in an emerging market (EMC) decides to raise funds by issuing a bond denoted in dollars. The EMC local currency is rising as a result of dollar weakness. The EMC converts the dollars to local currency and as the local currency strengthens, the debt in USD shrinks. His balance sheet looks great and of he goes to his local bank and using his balance sheet as collateral, he takes out a further loan in dollars. And so the dollar debt grows. Now its 2014. Out of the blue, the dollar begins to rise. The EMC has dollar debt which it cannot cover by converting local currency into dollars. As the dollar rises against the local currency, the US denominated bond holders see this and begin selling. This sends up interest rates (yields) to stressful heights. A major slowdown. Now multiply by zillions.

This is what is happening in countries that represent at least 50% of world GDP. Now add Europe and Japan. In 2014 the dollar has risen by an average of 13% against a basket of international currencies. Bottom line, international debt has risen on average by 13%. Most International oil contracts are denoted in dollars and this raises the question. Is the year 2015 the year in which OPEC unravels? Who will go down with them? Will the central banks continue to co-operate or is it every man/woman for him/herself?

The rule of bubbles is that all bubbles come to an end. In this case there appears to be a bubble within a bubble and the only question is how rapidly the air escapes from these balloons.  Slow and easy or......perhaps this is just paranoia at work.

Hopefully the logic in this blog is coherent. If not, please don't hesitate to drop me a line. I welcome fruitful discussions.

Doug Kass, “When everyone thinks central bankers, money managers, corporate managers, politicians or any other group are the smartest guys in the room, you are in a bubble.”

Barry Ritholtz, “I am hard-pressed to recall when any sort of bubble was accurately identified in real time on the cover of a major media publication. If anything, the opposite is true.”