Up Or Down?

After weeks of positive sentiment across all equity markets, Friday saw a pullback. Let's be fair, you cannot be all running at the same time and see no pullback. But its interesting to see what the media and experts say were the reasons for the pullback.



a) China was making news all week, and on Friday the Shanghai Composite rattled world markets with a sudden 5% drop on inflation fears and the threat of tightening by the government. Is this a surprise? Of course not. What is more important is sentiment is still good and the pullback is just a breather. When you run for sometime, you have to pullback even if there were no bad news.

b) US municipal bonds took a huge hit and could be flashing danger signals for further problems to come. Muni prices have plunged as concerns about municipal debt and default continue to grow. So far this has been a back burner issue as everyone has assumed that the Federal government would bail out the states and municipalities, but with QE2 and a new House of Representatives in town, confidence in this outcome seems to be on the wane. So when did the rest of the markets really care about US housekeeping issues?



c) U.S. policy makers had a bad time at the G-20 meeting and while they were getting beaten up there for QE2 and devaluing the dollarIn Seoul, President Obama failed to get a much ballyhooed trade agreement with Korea, and the U.S. delegation took heat from countries like China, Brazil and Germany for devaluing the dollar at their expense. Later in the week, the Chinese again expressed their displeasure with current affairs as Commerce Minister Chen Deming said they didn’t support quantitative easing and espoused on the risks of growing more global bubbles. These are policy concerns, not liquidity driven issues.

d) While investor sentiment remains at extreme bullish levels. However in the U.S., insiders didn’t share the same optimism and set records for selling at a 12-1 ratio, perhaps sensing an interim stock market top. This is a concern.

e) In reality, US data has turned slightly more upbeat, reflected in higher US yields.



f) As the USD recovered, commodity markets have fallen back to earth with a thud, causing some to say the commodity bubble has burst, that's bull. A weaker USD caused a rally in commodity price, a slight rebound in USD would do the same in reverse, and since when we have a commodity bubble???

g) Debt worries are widespread in the Euro zone, the market is currently fixated on the Irish situation. Rumors are currently circulating that EU talks are underway that will lead to a financial rescue plan for Ireland as early as next week. Ireland’s Finance Ministry stated it had made no application for emergency funding from the EU and the European Commission said it has not received an aid request from Ireland. They are going through the motions. The Ireland issue is much smaller than the Greek's crisis, and the ECB have to do likewise and bail them, so what.

Being bombarded by various news and opinions can make one confused on market direction. Like I said before, all markets are running for quite some time, they have to pause even if there were no bad news. What's irksome is the business channels and media have to write "something" to explain the markets' pullback. As you can see, there are a plethora of reasons if you want a reason to sell.

I do not see any of the given reasons as anything new, we all know that. What is real is we are in for a low interest rate environment. The USD is moving down on QE2 and rebounding every now and then but the downtrend is there, which will move commodity prices higher and support US equity prices as well.

Elsewhere in emerging markets we are on a tear, or rather just starting. Its not a long drawn correction, its a blip. Thing should move up this week.

Important View On Dubai World Factor In Equity Strategy

Well, just as swiftly foreign money came into emerging markets, just as swiftly will they leave, and not even on something direct. An indirect scare out of Dubai seems to be enough reason to take the chips from the table. On Wednesday, Dubai World, the government investment company behind some of the emirate's most ambitious projects, said it was seeking to delay repayment on a tranche of its debt. The company has $60bn of liabilities from its various companies including Nakheel, the property firm behind the Palm Jumeirah, the world's biggest artificial island, and the Nakheel Tower, the world's tallest building at 1km high. It also owns DP World, the ports operator that bought P&O Ferries. Nakheel is due to make a $3.52bn Islamic bond repayment, plus charges, on December 14.

Traders feared that the request for a six-month standstill was a sign that the Dubai Government was struggling with its other debts – and that the full impact of the financial crisis globally may not yet be over. British bank stocks, that are among the most exposed in the world to the Middle East, were hard-hit. Royal Bank of Scotland slumped 7.75pc, Lloyds Banking Group lost 5.75pc and HSBC fell 4.4pc – all three are among nine banks who were book runners on an outstanding $5.5bn syndicated loan to Dubai World in June 2008. HSBC's interim accounts showed that the bank had a $15.9bn exposure to the whole of the United Arab Emirates.

The concerns for UK banks also hit sterling, which fell to its weakest point in a month against the euro and a basket of currencies, while gilt futures leapt to a six-week high, propelled by renewed fears about credit quality. Property shares fell sharply amid concerns of a fire sale of Dubai's UK assets, which include the Grand Buildings in London. Dubai has also been a major buyer of UK property.

The risk of corporate default in Dubai clearly shows that contagion risks have not disappeared and that perhaps the market has turned a little complacent about risk. Foreign money flew out of emerging markets yesterday and the cost of borrowing shot up as investors sweated over the prospect of a state-owned Dubai company defaulting and sending another round of shock waves through the global banking system.

Banks in Europe and North America are heavily exposed to the Middle East, and Dubai in particular, with its $80 billion of debt. The cost of borrowing money increased sharply with the increased risk in financial markets. Credit default swap rates (CDS) rising on debt issued out of the Middle East and emerging markets rose, and borrowing costs on Dubai's five-year loan jumped to 5.4 per cent, up 2.24 per cent in two days.

If you look at the emerging nations' stock market performances it gives you a feel of how quickly Western capital will flow out of these nations on default fears. That said, we have to acknowledge that this is largely not long term funds anyway. These funds will find some obscure reasons to get out, if it wasn't this Dubai World situation, it will be some other obscure factor. Thats part and parcel of the high risk of having carry trades into your system. You can complain when they exit, but somehow the same people never seem to complain when they arrive??!! (ala Mahathir).

If nothing is resolved for Dubai World in the next few days you could expect more of the same next week. Uncertainty will breed fear, in other words. However methinks the risk of contagion is relatively low this time around - plus it came at a time when most equity markets were quite robust, and were actually looking for a reason to correct. This would be a good reason to correct - but I would have to say that its a buy on weakness this time around, rather than a "go for a few months holiday" kind of correction. I think markets should have a few more days of weakness, and a good strategy would be to slowly build up positions.

One big thing which most of the Western media have neglected is the role of Abu Dhabi/UAE in this - many seemed to just gloss over this. Abu Dhabi won't allow Dubai's state-owned companies default on debt payments as the global banking crisis limits their access to funds. Dubai and Abu Dhabi are interdependent and one can't be isolated from the other. Abu Dhabi Investment Authority is the world's largest sovereign wealth fund with assets of between $250 billion and $850 billion, according to the International Monetary Fund. The emirate owns more than 90 percent of the U.A.E.'s oil reserves, nearly 8 percent of the world's proven total.

Take all that into account, the risk of contagion and another credit crunch was low. Because seriously, the Middle East is not the engine of growth or a crucial part of the recovery we are seeing in the global economy. The sums that the affected banks will have to bear are not overly large, they can be written down safely, yes these banks' share prices will take a hit, but its nowhere as bad as the subprime situation.

p/s photo: Haruna Yabuki