The game is over

From Knight Research. Presented without commentary.
The Game Is Over
The simple story is this: We believe the structural and cyclical terms of global trade have finally reached their tipping point. This will catalyze a wholesale change in sentiment and a historic repositioning of risk assets. The emerging market global growth story is over.

• In meetings with clients throughout October, we began emphasizing our growing concerns about the nearly ubiquitous confidence the financial markets—and for that matter, global leaders and their body politic—have in China; and by extension, the rest of the emerging market story, commodities, and the direction of foreign exchange cross-rates.
• Not surprisingly, our concerns were met with varying degrees of resistance; but the overall consensus clearly favored a very bullish, asymmetric outcome over both the near and intermediate terms. When pressed as to our own sense of timing and specific catalysts  for broad-based trend reversal, candidly we were unclear. Our sense then, was that the higher and faster the commodity markets pushed, the sooner the reversal would occur. But we have now clarified our view.
• In just the past several weeks, we believe the data and government actions out of China, the back-up in US interest rates, the Fed’s emphatic commitment to QE2, intensifying pressures across the EU, broadly rising commodity prices, government efforts to control hot money flows, have finally pushed the global terms of trade to their tipping point.
• And now, as is evident by the flight to safety, and growing evidence that China will soon try and effect price controls in addition to raising interest rates and significantly changing the rules for their vast network of Local Government Funding Vehicles (LGFVs); the writing is on the wall. The game is over.
• The simple story is this: The structural and cyclical terms of global trade have reached their tipping point which will effect a wholesale change in sentiment and a historic repositioning of risk assets.
• So what do we consider the “terms of global trade”? Structurally, per our top chart, they are the intersection of Government Policy (viz., rule of law, market systems, trade law, etc.,) Resource and Industry (viz., natural resources, labor/demographic pools, industrial advantages, import dependencies, etc.,) and Economic Security (viz., the sovereign’s competitive standing, the relative power/needs of the citizenry, the mandate/control of the government, etc.) And cyclically, (as represented by the light blue, bold arrows) the terms of trade are defined by the intersection of foreign exchange rates, commodity prices, and the cost and availability of trade finance.

• And in our assessment given:

1. The structural breakdown of the credit and labor markets in the developed world and the anemic outlook for nominal GDP growth
2. The immaturity of the developing world and their vulnerability to credit shocks and uncontrollable inflation
3. China’s dependence upon non-economic, and unsustainable credit expansion to maintain growth far beyond natural export and domestic demand, and
4. Asia’s dependence upon imported energy and agriculture

the game is over. Presently, we believe that the broad-based resurgence of investor confidence in the emerging market and secular bull market in commodities will end badly; proving that the rally which commenced in Q2 2009, was in fact an “echo bubble” facilitated by massive—and unsustainable—stimuli from the Chinese Government

• And although such cataclysmic shocks rarely result in rhythmic, straight line fractures, the chain of price adjustments should be  relatively clear. Accordingly, we expect a shockingly powerful rally in the dollar, broadbased weakness across the commodity sector, a dramatic widening of emerging market credit spreads, and what could prove to be a stampede of hot fund flows out of the emerging markets.
• We appreciate both the gravity and the brevity of this note; but then again, the story is simple.

We believe that the end of the Great Consumer Credit Cycle and the vast structural differences in the terms of trade between the United States, the EU, and China, have finally caught up with the secular bull thesis on Emerging Market and Commodities. Quite ironically, the Fed’s aggressive policies will likely prove to be the catalyst which breaks China’s unbridled expansion of credit and non-economic growth, ushering in a wholesale rebalancing of risk assets.