August 25, 2008
Credit Risk Spreading Beyond Financials

The stock, bond and foreign exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession.

I'll emphasize again that at the point we do observe sufficient evidence for investors to concede recession, the potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact. As I've often said, the best time to panic is before everybody else does.

Among the factors that concern me here is the continued widening of credit spreads, which increasingly suggests that default risk may be starting to spread beyond the financial sector into the broader economy. Meanwhile, there is a relative complacency in the stock market because investors are still convinced that the extreme “tail risk” in the markets has been removed by the Federal Reserve and the U.S. Treasury.

Typically, low volatilities are observed prior to poor market performance, with the worst performance often following a low VIX that breaks out moderately to the upside. For that reason, fluctuations in the VIX, particularly any move beyond 25-27, are worth watching here. At the point of recognition, we may very well observe abrupt weakness in both stock prices and the U.S. dollar.

Meanwhile, oil and precious metals prices continue to deteriorate (though we did get a brief spike last week which gave us a chance to clip off the precious metals positions we established on prior weakness). While the selloff in oil prices is viewed by some as a “stimulus” for the economy, this is a classic mistake of confusing shifts in a demand curve with movements along it. Put simply, oil prices are weakening because the global economy is weakening. That represents a shift in the demand curve. You do not then read the lower oil prices off of the graph and assert that the lower prices will lead to a stronger global economy.

I continue to view commodities as being at risk for further price deterioration, even in the event that the U.S. dollar itself weakens. That's another way of saying that, from the perspective of other countries, commodities prices can be expected to decline by an even greater amount than the U.S. dollar.