The first sign of weakness in commodities this week is evidence that markets have begun to think about economic weakness as a potential consequence of the escalating distress in the world of credit, says CLSA‘s Christopher Wood in a particularly sweeping issue of his client newsletter, Greed & Fear.

“It would be extraordinary if the credit universe continued to deteriorate and there was no ensuing growth scare.” A commodity correction would be a “natural symptom” of such a scare, and is likely to happen in coming months, says Wood. Such a commodity correction is also likely to put upward pressure on emerging-market debt spreads, which already show signs of greater correlation to the rising credit spreads seen elsewhere.

“None of the above is to deny the strength of the long-term commodity story, based on the demand stemming from the emerging world”, he says. “Still it is also the case that the world has not completely decoupled from the US economy. A sudden sharp decline in the US current account deficit would represent a deflationary shock for the global economy even if it would be bullish for the beleaguered US dollar.”

This leads Wood to the question of the strength, “or otherwise”, of the US economy. The most recent US GDP data showed a clear slowdown in US consumption, as the knock-on impact from the collapse in US residential investment finally kicks through. This weakness in consumption is likely to continue “for the simple reason that the weakness in housing is likely to continue”, says Wood. The Achilles’ heel for the US housing sector remains the alarming arithmetic on the “resets” on the adjustable-rate mortgages, he notes.

A key issue ahead for the market will be evidence of housing weakness spreading to the rest of the US economy. Here, says Wood, “the obvious point of tension remains the labour market”, with all the risks pointing to the downside.

US core inflation, meanwhile, is now back in the acceptable range. But it will become much easier for the Fed to ease if what Wood calls the “oil-led commodity complex” also undergoes a correction. Otherwise, he warns, Ben Bernanke “may be put in the uncomfortable position of being asked to choose between the contrasting messages sent by a surging headline inflation rate and a growing clamour to cut rates to bail out Wall Street in the context of an intensifying credit contraction”.

On an even cheerier note, Wood warns that “the US financial-services sector is going to pay the financial consequences of its massive abuse of securitisation, as will its overseas clients who bought structured finance products out of a dubious search for yield.” He also continues to predict that “if things get really bad on main street, securitisation will again be outlawed as it was in 1933 by the passage of the Glass-Steagall Act.”

Investors should expect the focus on financial problems to extend increasingly beyond securitised mortgages to the leveraged loan market, he warns. “The other less appreciated risk is banks’ exposure in terms of their lending to credit hedge funds and to funds of funds investing in hedge funds”, he says, warning of the continuing “potential for systemic risk in this little understood area”.

Credit hedge funds, in their “lust for yield”, have been increasingly buying leveraged loans direct from the banks, notes Wood. The value of such loans is now plummeting. It is not clear what the wake-up call would be for the end investor but obviously, “that wake-up call is coming”, he says, “as are a flood of lawsuits from end investors in structured finance ‘capital guaranteed’ products.”

Falling US Treasury bond yields, meanwhile, are bearish for equities which is why Asia, in the short term, will continue to be hit by an intensifying growth scare. But in the longer term, the collateral damage from escalating solvency worries spells what Wood sees as “a massive buying opportunity for Asia”. In fact, he says, Asia and emerging market asset prices are likely to be the beneficiaries of the next bubble stemming from the coming Fed easing. There is also potential opportunity for Asian buyers (the Chinese government?) to acquire distressed US financial service franchises – but, says Wood, “there will be plenty more bad news before that day arrives”.

America has enjoyed a securitised credit cycle and now risks the deflationary consequences. Wood’s view is that Bernanke, “to his great credit, is clearly less willing to exercise the ‘put option’ than his politically-oriented predecessor, ‘Pinball Alan’.” The Fed chairman also probably sees the increased risk aversion as healthy, Wood notes, and “will be willing to fly his helicopters only when there is hard evidence of a deflationary threat to the real economy.”

But for such an event to happen, he says, “Wall Street will have to have suffered a lot more downside in the interim”.

Liquidity preference is now rising, as the asset-backed securities boom starts to unwind. “This threatens wealth destruction on a large scale, most particularly if concerns creep into the asset-backed commercial paper market, which is what US money market funds are stuffed with.”

While he steers clear of predicting with certainty such an event, Wood notes that the “risks of such a Minsky moment are arising, which would definitely prompt the arrival of Bernanke’s helicopters. But as ever in markets, it will probably take time to play out.”

Well then, there’s time, at least, to have a happy weekend…

This entry was posted by Gwen Robinson on Friday, August 10th, 2007 at 13:16 and is filed under Capital markets, Hedge funds. Tagged with christopher wood. Edit this entry.