Monday, January 22, 2007

How China could sink Wall Street

If you buy lots of things on credit but can pay your interest, your business will probably survive. But as soon as the bank decides they don’t want to lend you any more money, you have a problem. Other banks are likely to decide they don’t want to lend to you either and things can go from bad to worse in a hurry.

In November (the most recent numbers available) the United States had a trade deficit of $58.2 billion. That is to say that we received goods worth $58.2 billion more than we shipped out. That would be the buying more than you pay for part.

In November the net foreign acquisition of long maturity U.S. Securities measured $58 Billion. In other words the people we bought the goods from in other countries collectively turned around and cashed in their I.O.U.s for American Debt. That would be the part where our trade partners are lending us money.

So far so good, right?

Well, the tide may be turning. That $58 billion in November was down 23% in one month from $74.9 Billion in October. That would be the part where the banker is deciding they maybe don’t like lending to us anymore.

For the time being business (and buyouts in particular) have been riding the cheap loans available due to massive capital inflows from overseas. Buyouts today use far fewer junk bonds and far more bank lending, which is cheaper and made possible by combining bank lending into Collateralized Debt Obligations which in turn have been feeding overseas interest in investing in the US.

If the interest in buying our debt goes down the price of borrowing will rise as borrowers have to pay more interest to attract money. This would probably make leveraged buyouts less attractive while simultaneously raising the cost of doing business. Such a double whammy combined with slowing profit growth would probably hammer the markets.

Got it so far? Less desire for our debt equals higher interest on corporate loans plus higher business costs equals a declining market.

The logic is good, but what about counter-forces? The usual savior of a lively capitalist system is another mechanism taking up the slack. In this it might mean the Federal Reserve lowering interest rates to help business. Unfortunately one of the main reasons people are no longer buying as much US debt is that many of the other central banks around the world are raising interest rates, making it more profitable to buy their debt. In this particular case as the US lowers rates to help the economy, the loan market may get worse before it gets better.

For the moment there is still strong enough cash inflow to keep things going, especially in the private debt market, but this concern is one of the reasons the market has been dropping recently even as oil drops (the other reason the market is down would be weak earnings, but I’ve already written about that).

There are a number of potentially nasty scenarios out there, which led the World Economic Forum to argue in their 2007 report that people have fundamentally underestimated the risks in the world. Experts express that risks have been rising all across the 23 areas the group studies.

These world risks are NOT typically priced into the market right now, which suggests that when one or more shocks hit we could be in for a serious crash. This increased risk is also why I have not recommended any bond purchases yet. Right now I can get 5.05% on my cash holdings, and the only bonds paying more than that are too risky or too long to be worth it.

I realize I’m sounding like a broken record here, but I really can’t stress enough: Position yourself defensively. If you go through the archives you’ll see I’ve called a number of entry and exit points and a number of times when things wouldn’t happen (which is far harder to do as a writer, since it’s so boring).

Invest Well,

FW



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