Twin essentials of driving and eating push world markets

Thanks to the world's addiction to driving and the much more essential chore of eating, the fundamentals favour commodities

Analysts say that the sell-off in commodities and related equity markets is being driven not by supply-demand fundamentals, but by the unwinding of hedge funds hit by the widening credit crunch. Highly leveraged, the hedge funds are forced to liquidate cash positions if capital gains don't allow them to meet interest payments. So any sudden shift in the funding environment could trigger a broad sell-off by hedge funds that contradicts the macroeconomic reality. The drop by the pound and Euro against the dollar in recent weeks - the pound has fallen 10% in the last month -- is apparently one catalyst behind the latest retreat by hedge funds and one that has hit emerging market equities very hard.

Notice that I didn't refer to this as the dollar's rally, even though the dollar rallied sharply in response to the US government's takeover of Fannie Mae and Freddie Mac. Rallies most often imply positive developments. But economists point out that the dollar's rise is more an expression of the fact that the rest of the developed economies now appear to be sliding along with the US into recession than any new appraisal of America's near-term prospects. In fact, it now appears that the focus of concern in global markets may shift away from the US - where things really can't seem to get any worse - to Europe, where the most certainly could. Europe's consumers appear to be succumbing for the first time in a decade to concerns that their economies are likely already in recession and are spending less.

Thanks to the world's twin addictions to driving and the much more essential chore of eating, however, economists say the fundamental argument in favor of commodities remains and that in both food and fuel, supplies are tight and vulnerable to supply shocks like force 5 hurricanes. So while stagflation has faded as an investment strategy for the time being, it may yet return, with the appetite for emerging market equities favoring commodities producers and countries with strong current account balances. Countering this will be fears that the developed world slowdown will have a greater-than-forecast impact on global growth. If developing world growth fell lower than, say, 6-7 per cent, it would be disastrous. Real growth would be largely negative and unemployment would rise rapidly. Amid high inflation, this would be a recipe for civil unrest and political upheaval.

This has helped tighten liquidity in the Gulf, a region where oil revenues and government spending are supposed to be creating loose liquidity. But hedge funds aren't the only reason, according to bankers and financial executives. Part of the problem is a simple question of competition: with funding costs and interest-rate spreads rising everywhere, borrowers everywhere have to pay more and investors tend to move capital where the returns are highest and the risk lowest. The Gulf's own investors and sovereign funds have a world of choice for their capital and don't have to keep it here if returns are not competitive. And the risk is clearly high. Not only is there the ever-present political risk, but there is regulatory risk, as well as inflation risk and operational risk, the kind that translates into things like paying thousands of dollars a month for flats that don't have running water or reliable plumbing. As the real-estate analysts here in the UAE say, quality is becoming the primary issue.

The other problem is the peg. Investors moved a pile of money into the region earlier this year speculating that central banks would allow their currencies to move upward against the dollar to help fight inflation and reflect their growing, oil-driven trade surpluses. That they haven't means that not only is inflation likely to remain in double-digits, eroding any earned profits, but that investments here have to be treated as dollar-denominated. Despite the dollar's rally last night, most people still believe the dollar is likely to remain under pressure and last night's seizure of Fannie and Freddie provides new evidence as to why. Buying up whatever new shares the two mortgage giants need to issue to offset the red ink they'll be ingesting as they buy up mortgage-backed securities will cost the US government plenty, some estimate up to $25 billion. In the meantime, the dollar appears to be rallying on hopes that the rescue will help end the housing slump.

Then there are other local risks, in particular the increasingly rickety property market. While bankers and property executives are quick to point out the prudential lending standards here remain high, the 1) absence of a robust credit bureau, combined with 2) a perception that the regulator - i.e. the central bank - lacks sufficient resources to adequately enforce those standards and that 3) breaches are common and pervasive, leads many to believe the potential for widespread losses should property prices falter is high. Recent investigations into alleged fraud in Dubai's property sector are not building confidence in asset quality.

Add to this that Gulf borrowers have an estimated $60 billion in debts they need to refinance in the next year. Many in the financial industry fear that the cost of rolling this debt over in the current credit environment is going to be higher than most people think. [e-mail]