Global Equity Markets Tumble…

Good day… We had quite a wild ride yesterday as the U.S. stock markets fell more than 4%. As you have all probably heard by now, the blame for this massive sell off is being placed on the Chinese stock market, which plunged.

Apparently the sell off in the Chinese markets started with a rumor that the Chinese government was looking to start taxing capital gains. This has been denied by Chinese officials, who came out in support of stability in their financial markets. Overnight the Chinese market was one of the few that ended up with a slight gain, so the worst may be over.

This sell off in the Asian markets combined with Greenspan’s predictions of a recession and a disastrous durable goods number to send the U.S. equity markets spiraling downward. As the markets started to sell off yesterday morning, I misread the screens and shouted out to everyone on the desk that the Dow was off 500 points. Everyone got a good laugh after I had to admit that it was only off 100 points, but by about 3 PM I looked like a prophet!

There was a flight to quality with the treasury market seeing a lot of buying. The commodity markets sold off due to the ‘global slowdown’ and its effect on demand. The negative durable goods number also calmed the market’s inflation fears pushing the price of gold down.

So what will happen today? (The pressure is on since I called the 500-point drop yesterday!) Today we will see fourth quarter GDP, which is predicted to come in at 2.2%, well off the previous estimate of 3.5%. We will also get the personal consumption data along with the GDP Price Index, Chicago Purchasing, and new home sales. None of these numbers should support a broad based rally, as they all will likely show a slowing U.S. economy. I think we will see additional selling today in the equity markets.

Chuck said it best as we were discussing the markets on the way out the door last night: Nothing goes up forever. We were bound to see a sell off in the equity markets – especially in China, which had been appreciating at a breakneck pace.

With the possibility of more negative data today, we could see another drop and probably will see a test of the 12,000 level on the Dow Jones. As we have spoken about numerous times in the Pfennig and Review and Focus, the U.S. debts and deficits don’t justify the valuation levels that we have seen in the recent past. But enough about the equity markets, I’ll move on to an area I know a lot more about: Currencies.

The yen continued to gain yesterday, climbing more than 2% against the U.S. dollar. The Swiss franc also rallied yesterday, and with the emerging markets selling off we saw many calling it the beginning of the end of the ‘carry trade’. Others said this was simply a flight to quality and that it didn’t have anything to do with the carry trade. It was likely a combination of the two. There did seem to be a flight to quality, as the emerging market currencies of the Turkish lira and Brazilian real were down 3% and 2% respectively versus the U.S. dollar.

Mike Meyer, who sits next to me on the trade desk, pulled up a chart yesterday that made it abundantly clear that the carry trade was being reversed. The two best performing currencies yesterday were the Swiss franc and the Japanese yen. The worst performing were the traditional benefactors of the carry trade, the high yielding currencies of South Africa, Brazil, Iceland, Mexico, and New Zealand.

While the sell off in the South African rand could be blamed on the big drop in gold, and the selling off in Brazil, Iceland and Mexico could be blamed on a flight from emerging markets, the sell off in the New Zealand dollar confirms the beginning of a reversal of the carry trade.

Like the equity markets, the currency markets will be watching what happens today to see if this reversal continues. If the yen and Swiss franc continue to rally while the kiwi, Icelandic krona, and rand fall, it will be a confirmation that a reversal of this massive carry trade is underway.

Again, Chuck has warned readers that the carry trade is not a ‘one way bet’. The Japanese economy continues to grow and interest rates will have to be raised, making the carry trade more expensive. As with any highly leveraged trade, you don’t want to be the last ones to unwind your positions, so we look for increased volatility in these currencies and some more large jumps by the yen and franc.

Confidence in the European economy unexpectedly rose in February for the first time in four months as unemployment fell to a record low. German unemployment fell to the lowest in more than five years as economic expansion encouraged companies to invest and hire. This decline reflects evidence that Germany’s economic rebound will continue this year after growing at the fastest pace in six years in 2006. The rate of expansion and declining unemployment may fuel wage demands and increase pressure on the European Central Bank to keep raising interest rates, as inflation remains below its limit of 2%.

U.K. housing prices increased for a 12th month in February, a sign that three interest rate increases have yet to cool the property market. This hot housing market was the catalyst for a series of preemptive rate increases by the Bank of England over the past few years. I would think the BOE would look to continue to raise rates, which should be supportive of the pound sterling. Another increase in interest rates will likely push the pound to try and break the $2.00 level, and this time around I think it will make it past.

The rally in yen will likely be dampened today by a report out last night that showed that Japan’s industrial production declined the most in almost three years in January. Output fell a seasonally adjusted 1.5% from December, when it rose to a record. This decline may make it more difficult for the Bank of Japan to keep raising interest rates after last weeks move up.

Reports out of India and Malaysia also showed a slowing of economic growth. Growth in Asia’s fourth-largest economy, India, unexpectedly eased to 8.6% in three months, ending Dec. 31, as farm output increased at the weakest pace in two years. Malaysia’s economy grew at the slowest pace in a year in the fourth quarter, as exports eased amid weaker demand for electronics from markets such as the United States.

While these markets are definitely slowing down, a move from double-digit growth to just over 8% growth is not what I would call a big negative. An economy just can’t grow at +10% forever. I still feel these economies will continue to be the growth engine of the world, and their currencies still represent some of the best bargains out there.

Currencies today: A$.7876, kiwi .6991, C$ .8561, euro 1.3200, sterling 1.9586, Swiss .8182, ISK 66.99, rand 7.2705, krone 6.15, SEK 7.0292, forint 193.39, zloty 2.9678, koruna 21.44, yen 118.48, baht 34.17, sing 1.5282, HKD 7.8109, INR 44.27, China 7.7409, pesos 11.18, dollar index 83.79, Silver $14.28, and Gold… $674.15

That’s it for today…We are all anxiously awaiting the start of trading here in the United States. Regular readers shouldn’t be surprised with this sell off and should be properly diversified. Markets like these are the best justification for what we continue to push: Proper asset class diversification and the safety that it brings. Hope everyone has a great Wednesday! No more Wired Wednesday for me as I have given up caffeine for Lent.

Chuck Butler — February 28, 2007

The Daily Reckoning