Royal Bank of Scotland Warns Its Customers of a Financial Markets Crash

The initial reaction we had was that RBS was doing some 'reverse jawboning' on Monsieur Trichet of the ECB with regard to interest rate increases. We don't follow Europe closely but we think increases by the US Federal Reserve are strong dollar fantasies for all the reasons which we've outlined in previous discussions.

Still, its rare to read such a specific prediction of a 300 point decline in the SP within three months from a 'name' banking institution which ought to be in a position to render an informed opinion.

But it does fit with our bias here to be prepared for the worst, and if it does not come, then so much the better for us all. Our outdoor activities have blossomed into a case of Lyme disease, so we'll be working lighter hours for at least the next month or so while time and the proper medicines do their work. Too bad such an effective remedy is not in the medical kit of Dr. Bernanke. Or is it?

RBS issues global stock and credit crash alert
By Ambrose Evans-Pritchard
11:44pm BST 17/06/2008
UK Telegraph

The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist.

A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

Such a slide on world bourses would amount to one of the worst bear markets over the last century.

RBS said the iTraxx index of high-grade corporate bonds could soar to 130/150 while the "Crossover" index of lower grade corporate bonds could reach 650/700 in a renewed bout of panic on the debt markets.

"I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names."

"Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.

RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage.

"Globalisation was always going to risk putting G7 bankers into a dangerous corner at some point. We have got to that point," he said.

US Federal Reserve and the European Central Bank both face a Hobson's choice as workers start to lose their jobs in earnest and lenders cut off credit.

The authorities cannot respond with easy money because oil and food costs continue to push headline inflation to levels that are unsettling the markets. "The ugly spoiler is that we may need to see much lower global growth in order to get lower inflation," he said.

"The Fed is in panic mode. The massive credibility chasms down which the Fed and maybe even the ECB will plummet when they fail to hike rates in the face of higher inflation will combine to give us a big sell-off in risky assets," he said.

Kit Jukes, RBS's head of debt markets, said Europe would not be immune. "Economic weakness is spreading and the latest data on consumer demand and confidence are dire. The ECB is hell-bent on raising rates."

"The political fall-out could be substantial as finance ministers from the weaker economies rail at the ECB. Wider spreads between the German Bunds and peripheral markets seem assured," he said.

Ultimately, the bank expects the oil price spike to subside as the more powerful force of debt deflation takes hold next year.

SP 500 Futures Hourly Chart

The support and resistance seems obviously shaping into a rising wedge. In our experience these have a 55-45 probability of breaking to the downside and dropping down to the firmest base which here is about 1340.

However, they do have an annoying tendency to break to the upside, and then the formations on the daily chart tend to have more control over short term pricing action. If it clears resistance at 1380 we could see a short covering panic buy up to 1410.

This would not be inconsistent with this being an important quad witch expiration week.

In summary, the US economy is in a stagflationary recession, and the banks are working overtime with the Fed and Treasury to hide the rot in the crony capitalist financial system after multiple bubbles.

The real economy is about as imbalanced as any command economy can be, especially with the savings reserves of the better part of the world to play with.

In the short term the banks, lacking real world serious business potential, will continue to game the financial markets, so speculator beware.

US Stocks Are Likely Heading Towards a Major Reversal as Stagflation Intensifies

Stagflation is the most probable scenario for the US economy, despite the fog of statistics emanating from the federal government.

Stocks in U.S. Show Negative Return on Inflation Gain
By Michael Tsang and Alexis Xydias

June 16 (Bloomberg) -- Inflation is eliminating the rewards of owning U.S. stocks. Surging commodity prices have eroded earnings and spurred the Federal Reserve to consider raising borrowing costs just as equities are trading at their most expensive in four years. Standard & Poor's 500 Index shares yield 0.22 percentage point more in profits than the interest on 10-year Treasury notes, the smallest advantage since 2004, data compiled by Bloomberg show. The last time corporate earnings returned less versus bonds, the index posted its first quarterly decline in more than a year.

The 39 percent advance in oil, 61 percent jump in corn and 41 percent climb in rice pushed the UBS Bloomberg Constant Maturity Commodity Index to a record this year. That's squeezing profits as raw-material costs outpace consumer prices by the largest margin since the 1970s. Companies in the S&P 500 will earn 7.7 percent less in the second quarter than a year ago, according to analysts' estimates compiled by Bloomberg.

``We now have an inflation scare that comes on the back of an already negative backdrop in earnings growth,'' said Florence Barjou, 35, a Paris-based manager at Societe Generale SA's Lyxor Asset Management SA, which oversees $100 billion. Her $1.2 billion Lyxor Diversified Fund dropped all of its bets this year on rising stocks, contributing to the fund's 19 percent return in the past year in dollars.

S&P's Decline

Today, the S&P 500 rose 0.11 point to 1,360.14. The S&P 500 has slid 7.4 percent since December, the biggest year-to-date decline since 2002. Almost $400 billion in losses tied to subprime assets and the collapse of Bear Stearns Cos. sent the gauge to its worst tumble in seven years in the first quarter. After rebounding in April, the index fell 4.7 percent on concern record fuel and food costs will force the Fed to lift interest rates even as the economy sputters. Yields on 10-year Treasuries jumped on June 13 to the highest level this year.

Rising bond rates make the payout from fixed-income investments more competitive with stocks. S&P 500 companies yielded 4.28 percent in reported profit versus their share prices last month, compared with 4.06 percent from 10-year Treasuries, data compiled by Bloomberg show. The last time the gap between the so-called earnings yield and government bonds was narrower was in May 2004. A quarter later, the S&P 500 lost 2.3 percent.

Profits are declining as U.S. companies' input costs rise faster than they can pass them on to consumers. At the end of March, producer prices including food and energy rose by 6.9 percent, compared with a 4 percent increase in consumer prices, according to quarterly data compiled by Bloomberg.

Pricing Power

The last time U.S. companies had so little pricing power was in 1975, after the Middle East oil embargo ushered in a decade of stagnant growth and price increases known as ``stagflation.''

While economists project that U.S. growth will grind to a halt in the second quarter, inflation accelerated to 4.2 percent last month from a year ago. That's more than double the rate in August, just before Fed Chairman Ben S. Bernanke initiated the most aggressive rate reduction since the 1980s, cutting the target rate for overnight bank loans by 3.25 points to 2 percent.

``The Fed is in a tough space,'' Byron Wien, chief investment strategist at Pequot Capital Management Inc., a $7 billion hedge fund based in Westport, Connecticut, said on Bloomberg television. ``They've got all the commodities working against them. Even though the economy is slowing, the price of oil and agricultural commodities is rising, so that's creating an inflationary pressure.'' The 75-year-old strategist predicted in January that U.S. stocks would drop this year as the economy falls into a recession and inflation rises.

Emerging Economies

Demand for raw materials in emerging economies and a weaker dollar underpinned the record-breaking 27 percent jump this year in the average price of 28 commodities tracked by UBS AG and Bloomberg. Inflation now exceeds targets in 80 percent of developed and emerging-market nations where central banks have them, Abhijit Chakrabortti, chief global equity strategist at Morgan Stanley in New York, wrote in a note last week.

In response, at least two dozen central banks from India and Brazil to Serbia and South Africa have raised rates in 2008.

``Central banks are now worrying about inflation more than about growth,'' Richard Cookson, London-based head of global asset allocation research at HSBC Holdings Plc, Europe's biggest bank by value, wrote in a report last week advising clients to cut their equity holdings. ``That doesn't mean we now like government bonds more. But it does mean we like equities less.''

Global Inflation

The fastest gains in consumer prices since at least 1992 have sent Vietnam's benchmark stock index to a 59 percent drop this year, the biggest among 88 global benchmarks tracked by Bloomberg. Chinese shares slumped 45 percent in 2008 as inflation climbed to the highest in 12 years in February.

In the U.S., valuations have climbed as earnings of S&P 500 companies fell faster than shares.

Ford Motor Co., the second-largest U.S. automaker, abandoned a target of returning to profit next year on May 22 because of rising costs for steel and gasoline. The Dearborn, Michigan-based company's shares dropped 20 percent in the past month.

Whole Foods Market Inc., the largest U.S. natural-foods grocer, slumped 19 percent since reporting on May 13 a bigger- than-expected drop in quarterly profit. The Austin, Texas-based retailer said sales growth slowed as shoppers reined in spending.

Jonathan Armitage, New York-based head of U.S. large-cap equities at Schroders Plc, which oversees about $259 billion, says the share declines created buying opportunities because inflation concerns are overstated. Slowing global growth will cool demand for energy and commodities, and a U.S. recovery will bolster earnings within 12 months, he said.

``Concern about inflation will dissipate, and that allows the equity market to look through what is obviously a challenging economic environment,'' said Armitage, 38, who bought retailers and railroads this year.

Stanford Group Suisse AG's Leo Schrutt is less sanguine.

``Stagflation is a very real and likely scenario in the U.S.,'' said Schrutt, 51, senior managing director at Stanford Group in Zurich, which has $60 billion under management for wealthy clients in Europe. ``What does this mean for stocks? I personally am waiting for things to get a little worse.''

To contact the reporters on this story: Michael Tsang in New York at mtsang1@bloomberg.net; Alexis Xydias in London at axydias@bloomberg.net.

Morgan Stanley Warns Europe Against Pulling at the Fed's Leash

The drunkard warns against temperance, the wastrel warns against thrift.

"No good will come of this adherence to sound values!" cries the profligate.

And so the mighty Empire shakes, and fear creeps into the recesses of its highest towers.


Morgan Stanley warns of 'catastrophic event' as ECB fights Federal Reserve
By Ambrose Evans-Pritchard,
International Business Editor
UK Telegraph
1:29am BST 17/06/2008

The clash between the European Central Bank and the US Federal Reserve over monetary strategy is causing serious strains in the global financial system and could lead to a replay of Europe's exchange rate crisis in the 1990s, a team of bankers has warned.

"We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe," said a report by Morgan Stanley's European experts.

Just as then, Washington has slashed rates to bail out the banks and prevent an economic hard-landing, while Frankfurt has stuck to its hawkish line - ignoring angry protests from politicians and squeals of pain from Europe's export industry.

Indeed, the ECB has let the de facto interest rate - Euribor - rise by over 100 basis points since the credit crisis began.

Just as then, the dollar has plummeted far enough to cause worldwide alarm. In August 1992 it fell to 1.35 against the Deutsche Mark: this time it has fallen even further to the equivalent of 1.25. It is potentially worse for Europe this time because the yen and yuan have also fallen to near record lows. So has sterling.

Morgan Stanley doubts that Europe's monetary union will break up under pressure, but it warns that corked pressures will have to find release one way or another.

This will most likely occur through property slumps and banking purges in the vulnerable countries of the Club Med region and the euro-satellite states of Eastern Europe.

"The tensions will not disappear into thin air. They will find fault lines on the periphery of Europe. Painful macro adjustments are likely to take place. Pegs to the euro could be questioned," said the report, written by Eric Chaney, Carlos Caceres, and Pasquale Diana.

The point of maximum stress could occur in coming months if the ECB carries out the threat this month by Jean-Claude Trichet to raise rates. It will be worse yet - for Europe - if the Fed backs away from expected tightening. "This could trigger another 'catastrophic' event," warned Morgan Stanley.

The markets have priced in two US rates rises later this year following a series of "hawkish" comments by Fed chief Ben Bernanke and other US officials, but this may have been a misjudgment.

An article in the Washington Post by veteran columnist Robert Novak suggested that Mr Bernanke is concerned that runaway oil costs will cause a slump in growth, viewing inflation as the lesser threat. He is irked by the ECB's talk of further monetary tightening at such a dangerous juncture.

The contrasting approaches in Washington and Frankfurt make some sense. America's flexible structure allows it to adjust quickly to shocks. Europe's more rigid system leaves it with "sticky" prices that take longer to fall back as growth slows.

Morgan Stanley says the current account deficits of Spain (10.5pc of GDP), Portugal (10.5pc), and Greece (14pc) would never have been able to reach such extreme levels before the launch of the euro.

EMU has shielded them from punishment by the markets, but this has allowed them to store up serious trouble. By contrast, Germany now has a huge surplus of 7.7pc of GDP.

The imbalances appear to be getting worse. The latest food and oil spike has pushed eurozone inflation to a record 3.7pc, with big variations by country. Spanish inflation is rising at 4.7pc even though the country is now in the grip of a full-blown property crash. It is still falling further behind Germany. The squeeze required to claw back lost competitiveness will be "politically unpalatable".

Morgan Stanley said the biggest risk lies in the arc of countries from the Baltics to the Black Sea where credit growth has been roaring at 40pc to 50pc a year. Current account deficits have reached 23pc of GDP in Latvia, and 22pc in Bulgaria. In Hungary and Romania, over 55pc of household debt is in euros or Swiss francs.

Swedish, Austrian, Greek and Italian banks have provided much of the funding for the credit booms. A crunch is looming in 2009 when a wave of maturities fall due. "Could the funding dry up? We think it could," said the bank.