It is not a low probability that a cataclysmic event is unfolding in Europe. Over the past twenty years, cataclysms have been anything but rare occurrences (1995, ‘97, ‘98, 2000, ‘01, and ‘08 come quickly to mind). European finance is not functioning effectively; policymaking is dysfunctional; confidence is breaking down; and the region’s economies are in serious trouble (I know, "markets are oversold”). It is also apparent that major Credit Bubbles in China, India, Brazil and elsewhere are showing their age. While talk of capital flight from Greece, Spain and Italy garners most of the focus, there are maladjusted economic/financial systems round the globe that are quite susceptible to de-risking/de-leveraging dynamics and attendant reversals in “hot money” flows. Heightened global market stress, bouts of financial dislocation and a resulting global economic slowdown now appear likely. The extent to which dollar carry trades (shorting/selling dollar instruments to finance the purchase of higher-returning global risk assets) have accumulated over the years remains an important unknown.
My broad Credit-centric framework analyzes the situation in terms of a series of interrelated global Bubbles. Developing economy Bubbles appear increasingly vulnerable to the bursting of the European Credit Bubble. Speculators, investors and corporations have over recent years positioned for ongoing dollar devaluation versus emerging currencies. Hedge funds have enjoyed spectacular windfall returns, while U.S. multinationals have benefited from an international profits bonanza. And while I appreciate the notion of U.S. stocks and our economy as today’s so-called “least dirty shirts,” I at the same time see the potential for major disappointment and dislocation. The U.S. Bubble may very well prove resilient – but I don’t expect our risk markets to avoid what is potentially a radical change in the global financial and economic backdrop. And when things looked like they might spiral out of control mid-week, market excitement was almost palpable: “Here Comes the Policy Response!”