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Op-Ed: Will Troubles Abroad Stop a Countertrend Rally?

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Coming crises in China, Europe, Latin America could bring markets to their knees.

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Editor's Note: As an emerging-markets banking analyst, James Kostohryz has firsthand experience of banking collapses and their subsequent resolutions in Mexico, Argentina and Southeast Asia. Since leaving his position as Head of International Investments at Brazil's Banco Pactual in 2000, James has worked as an independent trader and investor.

I've been predicting that we'll see a consistent stream of releases showing a surprising upturn in second-derivative economic data over the next few weeks. This scenario seems to be gathering steam, and today's unexpected increase in housing starts (+22%) is just one small data point pointing in that direction. I expect a similar situation to manifest with data coming out of Japan (EWJ), Korea (EWY), and some of the Asian Tigers.

It's my position that improvements in the second derivative, together with frequent and increasingly coherent policy responses from governments and central banks around the world, could provide the basis for a countertrend rally that may be of greater magnitude than most currently believe. My own statistical work suggests that the window for a rally based on second derivative improvements is between now and June.

However, there's a major risk to the countertrend-rally scenario I've just described, and it has to do with developments outside of the United States. The effects of the global crisis are only now being fully felt in the rest of the world. My macro work suggests the effects of the crisis, which began in the US, will be felt in most foreign nations by April-May 2009. The full effects of the crisis on the domestic economies of most foreign nations will be felt by the fourth quarter of 2009.

Circumstances in Europe (EZU), Latin America (ILF) and China (FXI) are much worse than statistics are currently implying, and worse than the vast majority of US analysts and market participants realize. As the negative data from these countries start to hit the wires over the next few weeks and months, this will send global financial markets into the financial crisis's second phase, which will be accompanied by the realization that things are actually worse outside the US than in the US itself. International events will therefore become the primary driver of developments in financial markets.

First, with respect to Europe, the situation in the Mediterranean countries, particularly Spain and Greece, will be dire. Unemployment of 20%+ is a real possibility.

The inflection point in the European crisis will come in the summer, for 2 reasons: First, tourism is a huge driver of employment and general economic activity in southern Europe, and that will collapse. This will provoke widespread unemployment and bankruptcies in small and midsize businesses related to this employment intensive sector.

Second, the summertime is protest season, and I expect massive street disturbances to spread through Europe by virtue of the well known psychological phenomenon of the "copycat effect." The absolutely horrific situation in Eastern Europe (IEER) and the former USSR will add fuel to the fire and an element of geopolitical risk to the crisis vis-a-vis Russia.

EU mechanisms for dealing with a crisis of this nature are woefully inadequate. Tribalism is on the rise, and the centrifugal forces for EU dismemberment are increasing exponentially. This is only magnified by rising anger among ordinary EU citizens at the seeming indifference, rigidity and arrogance of the German position. Of course, this is reinforced by long-standing animosities.
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