The news that Dubai World (essentially the management company of Dubai) was going to seek an extension to credit terms was treated as being tantamount to a default by investors internationally and has generated a storm of media coverage. While I don’t believe this is going to be the catalyst for a sustained Global sell-off in stocks this event does raise yet more questions about market belief in the “recovery”.
Although the announcement did spark a short-term collapse in stocks and other financial asset classes, prices stabilised fairly quickly and have started to return to the previous highs. This can easily be explained by the fact that the “news” from Dubai cannot have come as much of a surprise. Even the most passive observer of Dubai’s growth cannot have failed to have recognised that the situation there was a classic bubble and was bound to cause problems. While the U.A.E. is oil-rich, the extent to which debt was used to drive Dubai’s growth was always likely to make it a victim of the Credit Crisis and ensuing Global downturn. This was just another bubble that had to burst one day.
However this situation does not look like another Icelandic crisis. It is true that Western banks seem to be exposed to yet more losses as a result of this default, but the sustained market reaction has remained localised to the Middle East. This suggests strongly that unless a genuine shock occurs and this event has surprising ramifications elsewhere, the Dubai situation will remain isolated.
However this is not to say that we should not pay attention to warning signals from this latest mini-crisis.
I am reminded of events in February 2007. You may or may not remember that there was a huge sell-off in stocks during this month in response to negative news on Chinese GDP. This sharp decline was followed by a strong rally, driven by expectations of US Federal Reserve Interest Rate reductions. I am sure I don’t need to remind you what happened after October 2007, when the financial World went into meltdown as the Credit Crisis really took hold.
So where do the parallels between then and now lie?
The answer is quite simple. As in February 2007 we have now witnessed an extreme, short-term sell-off in stocks belying genuine confidence in the economic soundness of the current rally. As with then, however, we are likely to witness a resumption of the uptrend driven by Central Bank financed liquidity. In short any concerns about the viability of the recovery will be trumped by the availability of substantial “cheap” money.
The speed at which stocks have recovered convinces me that we are likely to see the recent highs tested and broken in the run-up to the New Year.
Given the behaviour of markets since March 2009 any questions about the likelihood of other sovereign debt defaults, the latest failure of rating agencies to warn over Dubai’s perilous financial position, how well international investors have priced risk in Global Government debt or over the bubble characteristics clearly present in current financial-asset prices will be conveniently put to one side. Well for now at least….