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Monday November 30, 2009 - 16:26:08 GMT
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The sustained risk story

Key News
The Dubai government disclaimed responsibility for the debts of its Dubai World conglomerate on Monday, crushing earlier assumptions by creditors that the Arab emirate would guarantee its liabilities. (Reuters)
Strong performance in manufacturing and services helped India’s growth to shatter growth forecasts in the quarter to the end of September, raising the prospect of an early rise in interest rates.  India’s economy grew by 7.9 per cent year on year during the three months, data released on Monday showed, considerably above average expectations of 6.3 per cent.  (Financial Times)
British consumers repaid the  highest amount of unsecured credit on record in October,  reducing their debt at twice the rate economists had expected,  Bank of England data showed on Monday. (Reuters)
 
Quotable – Financial Times editorial today: “The cost of China’s excess capacity”
“The world has changed; but China has not. China has responded to the world financial crisis with what seems to be great success. But this is an illusion. China’s solution – a surge in spending on investment – will create greater excess capacity. China’s high- savings, high-investment economy is costly for its people and destabilising for the world. The time for a radical reform is long past.
 
“In a disturbing new report, the European Chamber of Commerce in China lays out the challenge in six sectors: aluminium, where the capacity utilisation rate is forecast to be 67 per cent in 2009; wind power, on 70 per cent; steel, on 72 per cent; cement, on 78 per cent; chemicals, on 80 per cent; and refining, on 85 per cent. Yet vast additional capacity is on the way.
 
“The scale of the excess capacity is breathtaking. At the end of 2008, China’s steel capacity was 660m tons against demand of 470m tons. This difference is much the same as the European Union’s total output. Yet, notes the report, “there are currently 58m tonnes of new capacity under construction in China”. To the extent that gross domestic product is driven by such absurd spending is a measure of waste, not of economic welfare. 
 
“Foreign producers fear the impact of China’s growing surplus capacity on their markets. But this is not just a problem for specific industries. It is a broader problem. China has become hooked on an unbalanced pattern of economic development, in which investment cures this year’s excess capacity by increasing next year’s.
 
“In China’s current development model, household income is taxed, to support corporate profits. Corporations now generate more than half of China’s huge savings. Since consumption tends to grow more slowly than GDP, excess capacity can only be used up via yet more investment or exports. This year, economic crisis has made the latter impossible. But China desperately needs to expand its exports once again. The result may well be a crisis in the trading system.
 
“China’s trading partners have to engage with the rising giant. They must explain that they cannot – and will not – absorb the surplus capacity its heavily distorted model of development is creating. But they can point out that this pattern also damages the standards of living of ordinary Chinese. China has to shift income from its corporations to its households and spending from investment to consumption. What is needed for that is a massive structural reform. This must start now. Indeed, it may already be too late. 
      Financial Times
 
FX Trading – The sustained risk story
Some suggests oil prices are too high thanks to overwhelming inventory levels and underwhelming global demand.  If we factor in the potential of central banks pulling in some liquidity they provided to the market, it sets the stage for a fall in oil prices.  Yet, many analysts expect the dollar will continue to be weak i.e. they are assuming a big change in the ongoing correlation: [Chart not available in text format.]

Thinking of this makes us think of a question we’ve been getting lately: How can you have anything good to say about the US dollar?  Good question!  Fundamentally there is little on the horizon to support any sustained dollar move.  Growth and yield support it lacks, to say the least.  We say the dollar rebounds on risk. 
 
Then the comment is this: Big deal.  The dollar gets a risk bounce on a correction in asset markets; then proceeds to work lower in its ongoing bear market.  This seems a very logical, and possibly the highest probability path from here.  But, we keep coming back to the idea of a risk event and the growing possibility such an event will be sustained and change the sentiment.
 
Stuff already on the horizon to trigger a risk event:
Dubai
Greece
Latvia
Ukraine
Hungary
Chinese excess capacity
Commodity excess capacity
Lack of lending in Europe and the US to the real economy
Investor complacency measure by a very low VIX
 
All stuff we know, likely much already discounted by the market, many analysts say.  Good point.  And as the global economy continues to recover, these problems will be dealt with. Also makes sense. 
 
But a lot, a whole lot, is predicated on continued global recovery.  What we think is being underestimated is the degree to which another financial accident could reverberate back into the real economy.   It’s the fool me once, crushing my housing wealth and 401k (stocks) during the credit crunch, then shame on me.  Fool me twice, with another hit to my 401k (stocks), shame on you.  That could be a game-changer in terms of sentiment.  
 
Why a game changer?  It goes to the socioeconomic stuff (which Robert Prechter does a good job of defining).  If we think we’ve seen rapid liquidation of private credit so far, just wait until we see another major stock market selloff.  Burned twice in risky assets, we think investors will be extremely hesitant to step back into the fray, finding better ways to use the money they have left—pay down debt and save.  
 
Why this could be critical and lead to a sustained risk event precisely from the fact that government stimulus is already lacking any power to provide much stimulus.  Coupled with the fact interest rates are already in the tank, and budget deficits are in the ozone;   government and central banks have used up most of their bullets already. 

Consumers in their shell in Europe and the United States makes that Chinese overcapacity (talked about in Quotable) all the more dangerous…a sustained risk event could emerge quite easily from this mix.  
 
Despite how much some hate to think about it, the US dollar rallies further on sustained risk than it would with your run of the mill bounces, a lot further we think.   
 
The path of least resistance for the dollar is down, the consensus view is clear and correct on this point.  So our sustained risk event story is only a story.  But then again the consensus was clear about that the little problem in subprime that would be contained in a small corner of the US real estate market, a couple of years ago.  
 
Stay tuned. 
 
Jack Crooks
Black Swan Capital LLC
www.blackswantrading.com 
 
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