I do not think I have ever seen a warning like this one. BMO literally says Go to Cash – In Plain English
We advocate switching out of equity positions and going to cash. The European sovereign debt crisis appears to be nowhere near over. The global credit environment is worsening. Cost of capital is going up and availability is going down. There are large gaps between where the credit market prices risk and where the equity market is priced. Equity is lagging the deterioration in credit conditions. Moves in currency, equity and commodity markets are mirroring the moves in the credit market. Global growth, in a credit-constrained environment, will slow. Profits will be squeezed by the higher cost of capital.
State of the Market: Credit vs. Commodities & Jobs
The frail state of the markets is now becoming more obvious and as such the audience for our call to cash is growing. The difficulty in getting our message out is that in its raw form (how we normally write), the argument is quite technical:
Client: Why go to cash?
Quant/Technical: Look at the euro-dollar basis swap pricing!
Client: Say what??
Now, however, the market is showing signs that everyone can easily recognize as indicative of economic weakness:
Job growth has stagnated, and
Commodities and inflation expectations are falling.
These new signs are not new information on why things are bad. Rather, they are symptoms, or outward displays of how weak the credit market has become.
Weakening credit conditions are the cause.
Economic fallout is the effect.
Western European Sovereign Debt Crisis = Asian Growth Problem
We observed that the sovereign default risk of Europe was very well connected to the sovereign default risk of Asia.
Then we tracked down the tidbit that European financials have funded Asia to the tune of more than half a trillion dollars.
By observation, we know there is a link and now we have part of the economic rationale for what we are seeing.
We have what we need for our call for extreme caution:
The funding of Asian growth is closely tied to the health of the European financial system.
Further, we know that the North American equity market is fixated on Asian growth.
Our equity market correction starting gun went off the moment Asian currencies, and thus optimism toward Asian growth, started falling.
The close ties between European and Asian credit are showing up in the tick charts only in times of stress, which is why we started picking up the relationship quite recently.
Growing Asian risk is equal to, outward capital flows, and ultimately a slowdown in Asian growth. An Asian economic slowdown in a capital-constrained world will bring forth lower global growth, and lower commodity prices.
European Sovereign Debt: Hard & Soft Asset Bubbles
Greece has started the process to sell private assets to raise capital. Publicly traded Greek stocks in which the government has a stake are falling fast, as investors fear large government sales.
The market is concerned that the German taxpayer will have to fund a Greek debt default spiral. Alternatively, euro holders worry that the German taxpayer will not fund Greece, leading to euro disintegration.
The market is now giving Spain a hard time, with Spanish government 10-year yields now higher than when the bailout package for Greece was announced.
The Spanish problem is also one of easy euro credit, which fed a construction, or hard asset bubble, that has now burst.
At the leading edge of the credit crisis in this case are Spanish regional banks, or cajas.
As the FT described succinctly; “the unlisted cajas – many of them politicised, linked to regional governments and with an opaque ownership structure – seized market share from the banks at the peak of the recent housing boom and now account for about half of outstanding loans in Spain. Several are heavily exposed to bankrupt property developers and homeowners unable to meet mortgage payments.”
There is much more in the report.
Without directly saying “go to cash”, I see no reason to have net long exposure here. Except perhaps for some exposure to gold, if you are not hedged, cash is the safe option.
Finally, if you do not know how to hedge, now is not the time to learn.
Mike “Mish” Shedlock
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