Edward Harrison — When market contagion occurs, this is how it will happen

I have been pretty sanguine about the markets and the US economy. Yes, the commodities complex is worsening, but that doesn’t mean this feeds through enough into other sectors to force the market down. And the real economy isn’t at stall speed yet either.We just aren’t there yet. Nevertheless, I have a general read on how this ends regarding credit cycle weakness, increased defaults, asset class contagion, falling markets, economic weakness, and recession. So let me sketch out for you the framework I’m using as a lot of the telltale signs of credit cycle weakness are already happening.

Now, to be clear, I am not calling a recession yet – far from it. After all, the Federal Reserve is raising interest rates, something that it does when the economy is doing relatively well. And while I don’t think the Fed necessarily gets it right, I don’t think they are that far off the mark. Yet, at the same time, the evidence is mounting that the credit cycle is pretty far along and that means asset class contagion and real economy weakness is not far behind.

Junk bonds and credit associated with the shale industry are now under pressure.

So how does this infect other markets? Whenever there is a system-wide panic, a large part of this is driven by people selling what they can, not what they must. So, what we need to – and eventually will see – is redemptions – mutual fund and hedge fund redemptions. And when people start to pull their money out of funds, that’s when previously uncorrelated assets become highly correlated.…

But inevitably you and some of your competitors will be forced to sell good assets too, not because you necessarily want to but because you must. And that’s where the contagion begins.…

Credit Writedowns
When market contagion occurs, this is how it will happen

Edward Harrison