Is another Black Monday crash on its way? The last was in October 1987, when a global slump began in Hong Kong on the 19th, spread to Europe and then to the US, where the Dow Jones collapsed 508 points on the day. By the end of that month the UK equity market had fallen 26 per cent, the US by 22 per cent and Hong Kong by 45 per cent, the ultimate ‘Black Swan’ event. In the last few days, a number of investment bank strategists have become decidedly twitchy (and not just about their employment prospects) with apocalyptic forecasts from Morgan Stanley and RBS among others, forecasting falls of 25-30% in key indices like the S&P. Technically, we have just seen a confirmed Hindenburg Omen (no, not a German horror flick; it’s a measure of an analomous divergence between stocks making new 12m highs and lows under certain defined conditions. Essentially, it indicates a dangerously schizophrenic market; the current extreme divergence between resources and financials is in these terms a warning of looming instability. Although it generates many false positives, it has preceded every major market slump of recent decades by 30-90 days). Current conditions are eerily similar to those leading up to the last Black Monday, with a destabilising coincidence of a weak dollar, mounting global inflation and rising interest rates, and a dangerous divergence between macro policy in Europe and the US. A point made by Morgan Stanley and other observers is that conditions in the US and Europe look pretty much as they did in 1987. Last time it was the Bundesbank’s decision to raise rates that prompted a switch into the Deutschmark and out of the dollar creating those tensions between the US Fed and the Bundesbank just a month before the October crash that many blame for Black Monday. The ECB clearly intends to raise rates this Summer despite fears over stagflation; if US inflation statistics were as rigorously calculated, they would certainly be at similar levels close to 4% (see US Inflation: A three card trick). In my view, interest rates are the wrong tool to control the current inflationary surge, which is driven not by excess domestic demand but by the speculative bubble in commodity markets; stricter regulation of those markets (including the restriction of index fund investment in food and energy futures) would do more to bring inflation under control that even the most aggressive rate hike. The current inflation is unusual in not being a domestic monetary phenomenon in the developed economies, and treating it as such will invite disaster. The tools required to tackle the inflationary storm emanating from the commodity markets lie in the arsenal of industry regulators like the CFTC rather than central banks. The tension this time is likely to be less between the US and Europe, as within the Eurozone. While Germany has boosted its productivity and is benefiting from booming exports to the emerging markets, much of the European periphery is sliding into recession led by a deep property slump in countries like Spain and Ireland. Current account deficits have soared to 10.5% in Spain and Portugal and 14% in Greece, all facing inflation close to 5%; if not locked into the Euro they would already be facing a crisis of confidence (indeed investors are already applying an historic premium to bonds issued in these countries over Germany). Meanwhile Eastern Europe is facing a crisis of its own (see Eastern Europe: The next bursting bubble?) Rather that instigating a new dollar slump as in 1987, I suspect a hike in rates by the ECB will put intolerable stresses on the Eurozone, which over coming months will be tested to destruction, to the benefit of the dollar, which is now building a medium term recovery. Elsewhere, I’d worry about the implications of massive speculative flows now flooding into China which may force a revaluation sooner than most expect, bad news for US inflation. I certainly wouldn’t take the prognostications of self serving investment bank Cassandras at face value. There is a lot of bearish sentiment in equities right now, from the record high short interest on the NYSE to the results of the latest Merrill Lynch institutional investor survey indicating very low allocations to stocks. I wrote back in April that I expected the bear market rally to reverse and probably test the technically important March lows on further bad news from the credit markets; whether we see a renewed downward leg depends on the oil price above all else. So long as oil prices crash soon (which I still think is likely absent a major supply disrupting event), the risk of equities doing so over coming months is greatly reduced.

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Commodities, Market Commentary