Gold dropped 20%. Oil dropped over 10%. The Goldman Sachs Commodity Index dropped 11%. The US Dollar rose. Last week? No, that’s what happened in the first week of July of 2008. Last week’s rout in the commodities markets was eerily similar to that week nearly 5 years ago when the first signs of the great financial crisis were coming into focus. Of course, things are a lot different now with QE forever here, NGDP targeting coming to the UK, the ECB doing “whatever it takes” and Japan finally focused on killing the dreaded deflation monster. Right?

Well, maybe, but Jeff Snider did some yeoman’s work last week on what is happening in the gold market (see here, here and here) and if his conclusions are right – and Jeff knows more about the inner workings of the global financial system than anyone I know – then there is some severe stress going on right now somewhere in the global financial infrastructure. I suppose it could be that gold and commodities dropped so quickly last week for reasons that have nothing to do with the financial system but if so, the reasons still aren’t benign.

What commodity markets seem to be signaling is a return to the deflationary atmosphere that prevailed in 2008. That might seem incredible in a world where developed world central banks are buying everything that isn’t nailed down but that’s what the market is saying and I for one take markets more seriously than the theories that motivate central bankers. The policies of the Fed and other developed world central banks have had an effect but it is not benign and it isn’t confined to the developed world. The rock bottom interest rates of the Fed have been transmitted around the globe and emerging market economies have spent the last few years building up debts that are starting to look ominous. Add in the entry of the Bank of Japan to the currency wars and you have a recipe for a crisis.

Everyone knows about the Chinese splurge of borrowing and spending after the 2008 crisis and many have credited the spending with saving the global economy. As with all things in economics though, there is no such thing as a free lunch and the bill may be coming due. What is less well known is that debt levels have been rising across Asia over the last 5 years. Hong Kong, Singapore, South Korea, Taiwan, Thailand and Vietnam – and other Asian countries to a lesser degree – have all seen their bank credit to GDP ratios rise significantly and are now at levels higher than before the Asian crisis of 1997. Hong Kong’s ratio has risen from an already high 183% in 2007 to over 275% now. Singpore rose from 87% to 137% while the other countries saw smaller but still significant rises. In other words, the Fed’s policies may not have spurred lending in the US but it has done wonders for Asian borrowers.

Alongside the debt buildup is a drop in exports due to the depression in Europe and the slow growth of the US. Asia’s current account surplus is now half what it was at the peak in 2007 and foreign reserve accumulation has slowed significantly as a result. At first glance it might seem that this is just part of the global rebalancing all the economists out there say the world needs. These countries are depending more on domestic demand for growth rather than exports. The problem is that the domestic demand has been driven by credit growth that is in turn driven by capital inflows. The crisis in 1997 was triggered by a reversal in those capital flows and the subsequent credit collapse. Could that happen again? I think so and the catalyst may well be the recent actions of the Bank of Japan to address their chronic deflation.

The BOJ’s announcement of massive quantitative easing has pushed the Yen down against the US Dollar and while that might be good news for Japanese exporters, it is causing heartburn in other Asian countries. With the market for exports already shrinking due to the lack of growth in the developed world the last thing a country like South Korea needs is for Japan to suddenly become more competitive through devaluation. The growth equation for Asian exporting economies is now a bit more complicated than just holding down their currencies in relation to the US dollar. Until now, they’ve been able to maintain growth by expanding credit for domestic consumption but if capital flows in suddenly become capital flows out due to diminished growth prospects, the credit expansion will come to an abrupt halt just as it did in 1997. And if it does, one of the few remaining props to global growth will be removed.

Emerging markets in Latin America face a similar situation. Much of the growth of the last decade has been driven by the commodity boom which in turn was driven by Chinese growth. With China’s economy slowing and commodity prices dropping, the growth outlook for Latin America is looking a lot less certain than it did just a few years ago. Consumer and corporate debt levels have also been rising although government finances are in much better shape than they’ve been in a long time. Even so, a commodity bust is not going to be good for Latin American growth and the emerging middle class everyone likes to talk about could easily submerge once again. Past debt crises in Latin America have been driven by excessive government debt but the risk this time is at the consumer and corporate levels.

The damage from lower commodity prices is not just confined to Asian and Latin American emerging markets though. Australia and to a lesser degree Canada have developed economies that are dependent on continued high commodity prices. Australia is especially vulnerable to an Asian slowdown that reduces commodity prices. In addition, African and Middle East economies are at risk as well as a Russian economy almost entirely dependent on high oil and commodity prices.

The wild card in this is the potential actions of the world’s central bankers. What will the Fed do if faced with a US economy that continues to slow in the face of their massive asset purchases? It seems unlikely they will just announce their defeat. What will Asian central banks do in response to the Bank of Japan and a weaker Yen? What will the ECB do if the banking system is really in as much stress as it appears to be? I suppose it is possible that they are all able to cooperate and come to a set of policies that continues to keep the entire global ponzi scheme going but it might also turn into an every country for itself free for all. The odds of a mistake that causes more harm than good are rising rapidly.

The drop in commodity prices last week, particularly gold, is a signal that should not be ignored. It is a warning about global growth and potential liquidity problems in the financial system. With the US stock market sitting within spitting distance of an all time high, the possibility of a similar drop in stock prices is not insignificant. The global economy has not been this fragile since 2008 and almost any outside shock could send us back into recession. The continuing slowdown in China along with the destabilizing actions of the Bank of Japan may be just enough to push us over the edge. I hope I’m wrong but it feels a lot like deja vu all over again.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.