I’m a fan of horror films, it’s the toughest genre to get right. The key is not to reveal the chainsaw wielding psychopath/demon/vampire too early, but intimate his presence gradually, building the suspense until he terrifyingly bursts on screen in the final act, splattering gore as he goes. If the director gets it right, by this point some delicate souls will be running for the exits and most brave enough to remain will be distinctly queasy. For those Wall Streeters heading back from the Hamptons next week (and given the record low NYSE volumes in recent days, the beaches must be packed) I suspect those with a taste for gore will have quite a spectacle to enjoy. Here are some thrilling plot twists while you were away:

1. Credit Spreads are exploding again, and are now at record levels. We have massive rollovers on buyout debt and US banks need to find $50bn in auction-rate securities buybacks alone in coming weeks, not to mention the ongoing Freddie and Fannie mess. Ominously, both the ECB and Fed are finally becoming more discerning about the quality of collateral they accept from banks in swap deals. Investment grade corporate bonds are trading at over a 300 point premium to Treasuries (from 100bp from 2005-7). If sustained, this will choke off corporate access to the bond markets and hence investment. Yet the VIX is still down at 20, and equities are still in half-hearted rally mode; experience tells me that when credit and equity markets diverge so sharply, the collective intelligence of the bond market usually proves prescient.

2. Tsar Vlad the Bad in Russia is now showing his true colours, and the invasion of Georgia and then recognition of the statelets seeking to secede is very dangerous; expect Russia to stir up its large minority populations in the Ukraine and the Baltic states to create an excuse for further intervention and expansion. Ultimately, this reckless hubris will undermine the fragile Russian economy and the Tsar will probably be overthrown by those Kremlin clans with an economic interest in engagement with the West, but in the meantime the uncertainty will destabilise markets. It’s about time the West clamped down on the massive money laundering and corruption that is endemic among the Russian elite all the way to the Kremlin; from Switzerland to Cyprus many billions in kickbacks and bribes are held in offshore accounts by Russian politicians and bureaucrats. That squeeze would hit harder and faster than any military or diplomatic threats…

3. Pakistan (the country with real WMDs the US should have invaded) is now teetering on the verge of political collapse amid an increasingly confident Islamic insurgency spreading from the Tribal Regions (where Al Queda are rumoured to hang out) to the cities; the army and intelligence services are clearly compromised by high ranking sympathisers. It’s increasingly possible that the next President will be the nuclear scientist who sold reactor and warhead plans to North Korea, Libya and Iran (almost certainly with the full knowledge of the ruling military elite, but he was a convenient scapegoat). Pakistan looks like Iran in 1979, except with a homegrown nuclear arsenal. A Taliban-lite style government in Pakistan is a truly horrible prospect, with particularly negative implications for Indian financial assets as military confrontation between the countries would inevitably resume.

4. After the recent grim data from Japan and the Eurozone, the G7 economies are now almost certainly headed for at least a mild recession in 2009; I believe that China is growing at just over half the 10% still being officially reported (note a slump in recent Chinese tax revenues, and a series of panicked reflationary measures in recent weeks; the statistics are about as phony as that Olympics opening ceremony). Emerging markets are now recoupling with a vengeance and face a nasty stagflationary cocktail; the IMF will be downgrading its wildly optimistic growth forecasts every month for the foreseeable future until we see 2-2.5% for 2009 global growth.

We may muddle through somehow, but the implications of all the above are likely to precipitate a crisis of confidence at some point this Autumn, as geopolitical risk converges with a darkening economic outlook. So far, earnings have been saved by the resilience of the global economy, but this is now clearly faltering, and the dollar has dramatically reversed course as I’ve forecast many times. In Q2, S&P companies that have at least 50% foreign exposure grew their earnings on average +20% for the quarter, versus domestically focused companies with 90% or more sales were US derived suffered a 36% slump in earnings. Both resource plays and US multinationals (notably the big tech stocks like Google) now face currency translation and revenue downgrades while the domestic economy is in recession in all but name. And this is the really horrifying bit; for the price multiple on peak earnings to touch the long-term average of 10.4, the S&P would need to fall to 885. Extreme perhaps, but I certainly wouldn’t be surprised to see the Dow sub 10,000, and the S&P sub 1100 as all this washes through in a climactic bear market sell off. So welcome back guys, and hope it was good. After all, next year, it’s a week in Atlantic City. Actually, I hear the Casinos there are hiring…

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Al Queda, army, Atlantic City, Baltic states, China, Cyprus, Ecb, Federal Reserve System, Georgia, google, intelligence services, International Monetary Fund, Islamic Republic of Iran, Japan, Libya, Market Commentary, North Korea, olympics, Pakistan, Russia, Switzerland, Taliban, Ukraine, United States, USD, Vlad, wall street