Ambrose Evans-Pritchard: The global slump has begun as poison spreads

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, May 12, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/12/ccambr...

The avalanche of bankruptcies has begun. Six US companies of substance have defaulted on bonds over the past fortnight, against 17 for the whole of last year.

As a "non-believer" in the instant rebound story, I am not easily shocked by gloomy reports. But the latest note by Standard & Poor's -- "The Bust After The Boom" -- gave me a fright.

The sick list is varied, though most for now are victims of the housing crash: Linens 'n Things, ($650 million), Kimball Hill ($703 million), Home Interiors ($310 million), French Lick Resorts ($142 million), Recycled Paper Greetings ($187 million), and Tropicana Entertainment ($2.49 billion).

As the Fed's latest loan survey makes clear, lenders have dropped the guillotine. With the usual delay, the poison is spreading from banks to the real world.

Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the rate of past downturns. "Companies are heading into this recession with a much more toxic mix. Their margin for error is razor-thin," she said.

Two-thirds have a "speculative" rating, compared to 50 percent before the dotcom bust, and 40 percent in the early 1990s. The culprit is debt. "They ramped it up in the last 18 months of the credit boom. A lot of deals were funded that should not have been funded," she said.

Some 174 US companies are trading at "distress levels." Spreads on their bonds have rocketed above 1,000 basis points. This does not cover the carnage among smaller firms outside the rating universe.

The California city of Vallejo (117,000 inhabitants) has just made history by opting for Chapter 9 bankruptcy, the result of tax erosion from a 26 percent fall in local house prices. Half Moon Bay may be next.

"This is the tip of the iceberg. Everybody is going to line up for Chapter 9 in California," said John Moorlach, Orange County board chief.

US consumers are juggling plastic to put off their day of reckoning. The Fed survey said credit card debt had jumped 6.7 percent in the first quarter to $957 billion, or $6,000 per working American, despite usury rates near 20 percent.

"My guess is that many Americans continue to run up massive credit card debt because they have little intention of paying it off," said Peter Schiff at Euro Pacific Capital. Quite.

Thankfully, the Fed's monetary blitz has averted a depression. Emergency lending under the "unusual and exigent circumstances" clause of the Fed Act -- the nuclear Article 13 (3), unused since the 1930s -- has put a floor under the banking system.

There will be no "reset Armaggedon" as rates vault on honey-trap mortgages. Drastic Fed cuts -- to 2 percent from 5.25 percent in September -- have conjured away that disaster, at least.

One dreads to think what would have happened if Fed liquidationists (Plosser, Hoenig, Fisher) had prevailed, as they did in 1930 -- and still do in Euroland, where Germany's Axel Weber holds sway, and nobody of sense dares lead a mutiny.

Despite the rescue, US house prices are likely to fall 25 percent from peak to trough (Lehman Brothers, Goldman Sachs). We are barely half done, yet 10 to 12 million households are in negative equity already.

The bears at Societe Generale are going into Siberian hibernation, issuing an "Ice Age" alert. They have slashed exposure to global equities to a minimum 30 percent for the first time ever.

Their weighting of super-safe "AAA" government bonds has been raised to a maximum 50 percent. This is a bet on gruelling "Japanese" deflation. The bank expects equities to fall by 50 to 75 percent.

"Nowhere and nothing will be immune. We are on the cusp of an equity meltdown that will slash and shred portfolios," said Albert Edward, SG's global strategist.

"We see a global recession unfolding. Liquidity will drain away and crush the twin emerging market and commodity bubbles. The recent hope that 'the worst might be over' is truly staggering. Profits are disintegrating," he said.

Today's "bear rally" may live on into June. Don't count on it. Global bourses are no longer rising hand-in-hand with oil in exuberant celebration of liquidity relief (US, UK, and Canadian rate cuts).

Crude ceased to be a friend of equities when it reached around $110 a barrel. At last week's close of $126, it became an outright threat. The Bush rescue package -- $800 in rebate cheques per household -- has been rendered null and void by the latest spike. The average US home is now spending over 8 percent of income on energy or fuel.

OPEC is playing with fire by refusing to pump more oil to offset rebel attacks in Nigeria. The cartel's output drop of 350,000 barrels a day in April is a hostile act at this point.

But there again, why should Middle Eastern states help America as long as the White House keeps filling the US petroleum reserve to prepare for war with Iran? Bush is playing with fire too.

The oil spike will burn itself out. China has hit the buffers. With inflation at 8.5 percent, it risks political turmoil. Moreover, it has repeated Japan's mistakes in the 1980s, building too many factories shipping too many goods at slender margins into a crumbling export market.

Lehman Brothers' Sun Mingchun says China will tip over in the second half of this year. "With so much latent overcapacity, an export-led slowdown could trigger a chain reaction which, in the worst case, could threaten the stability of [its] financial and economic system," he said.

Britain, Europe, Japan, and China will go down before America comes back up. This is turning into a synchronised bust, after all. The Global Slump of 2008-09 is under way.

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