The world’s largest economy, as you already know, is in recession too. In the U.S., financial capitalism is imploding. Citigroup’s CEO Vikram Pandit told analysts the company would lay off over 50,000 workers. He cited rising loan losses and an economy slowing much faster than the company previously expected.

Gulp.

As over-sold as we believe Australian stocks are at the moment, we’d be foolish to ignore the warning signs flashed yesterday all over the globe. Bill had better take down the crash alert flag and run up the depression alert flat.

World GDP is around $54 trillion. The U.S., Japan, and Europe combined have a GDP of $33 trillion (according to 2007 IMF figures). When 60% of the world’s economy is in recession (and the majority of the developed world) it cannot be a good sign for anyone…including manufactures of finished goods and producers of raw materials (China and Australia).

If you operate on the premise that share markets lead stock markets, then there’s the chance that this synchronised global recession is already factored into share prices. We know the small Aussie juniors are down 50%, 60%, or more from their highs. And as the chart below shows, the All Ordinaries has matched the S&P 500’s historic decline from the October 2007 highs.

If there’s any good news, it’s that Aussie stocks have underperformed the S&P for most of the third quarter. The S&P has lately caught up. But now we must seriously reckon with the possibility that the current world recession could turn into the first word depression. If that is indeed the case, then the argument for buying any shares at all gets that much harder to make.

Enter stage right Jim Lennon, resource analyst at Macquarie Group. Lennon published a research note last night in which he and his team forecast a 60% decline in 2009 coal prices, a 20% decline in iron ore prices, and a 40% decline across the board in base metals. It wasn’t quite metals Armageddon, but you could hear some of the seals popping with each forecast.

Keep in mind coal and iron ore are coming off big years in 2008, where thermal and coking coal were up triple digits and iron ore an average of 85%. In other words, the declines are coming off a big increase. But let’s not sugar coat it. These are sobering forecasts for resource demand and for resource producers.

Comm Sec analyst Savanth Sebastian says, “If it [Lennon's forecast] was the case, you’d see a lot of marginal mining projects go under and as a result you’d see a lot of processing plants close up shop,” he said. Unemployment will rise – maybe as high as 10 per cent – spending will be cut back, property prices will fall, wealth levels will fall. It suggests that overall things will be very grim and very dire.”

We wish we could tell you with conviction whether the worst of a global recession is already priced into shares are not. But no one can know. All we can say for sure is that if we are on the edge of Japan-like 15-year global debt/deflation recession/depression, then stocks will be a horrible place to be.

If you’re going to be in the market though, then you want to want to keep looking for those businesses and sectors that throw off cash, don’t have a lot of debt, don’t require huge infusions of capital to generate new income, and are located in the few industries in the global economy where good things are still happening.

Speaking of which, Diggers and Drillers editor Al Robinson just published his newest research today for paid up readers. As we’ve said, we realise a lot of readers are looking at the market and deciding to forgo it altogether. But our analyst team is still on the case, looking for the best ideas. You’d be surprised what you can buy on the cheap these days. This month, Al took a close look at the uranium industry in Australia…and found something he really liked.

It may be good timing. Western Australia’s Liberal government has fulfilled its campaign promise and officially lifted its ban on new uranium mines. The action affects some 1,475 mining leases in WA.

Premier Colin Barnett told the press that WA, “Is now open to the mining industry in this state, if they so wish, to proceed with plans to develop the uranium industry…We are the world’s leading mining economy and it’s always struck me as odd that we would have a ban on uranium mining when that is one of the areas of growth into the future,” he’s quoted as saying in today’s Australian.

What’s do you get when you mix recession and depression? Repression.

Source: Europe and Japan are in recession

One such figure came up yesterday. The total ‘value’ of global derivatives – financial instruments which are priced on the back of the underlying assets that they track – has now reached a breathtaking $596 trillion, after a mammoth rise over the previous twelve months.

That started the warning lights flashing…

So what, apart from containing more noughts than a normal human being can cope with, is this titanic number all about?

Let’s start by putting it into context. We can do this by checking out what the world actually made last year. The overall value of goods and services produced is measured by Gross Domestic Product (GDP). And for 2007, GDP for planet earth was reckoned by the International Monetary Fund to be just shy of $65 trillion. No less an organization than the CIA has come up with a similar estimate, at £65.8 trillion, so it must be about right.

So when the Bank for International Settlements (BIS) tells us that last year the total derivatives market grew by 44%, its fastest pace since the Basel-based bank started keeping records just over ten years ago, up go the antennae straightaway. And when that figure of $596 trillion crosses the radar screen, equivalent to more than nine times world GDP, the numbers are looking quite scary.

The money at risk is equivalent to a quarter of world output

Of course, the $596 trillion is a ‘notional’ amount. It’s the nominal value of all the underlying assets against which bets have been placed. But the actual amount of ‘real’ money at risk is still a massive $15 trillion, equal to almost a quarter of world output.

And within the individual areas there’s one even more eye-catching statistic. The value of contracts in credit default swaps (CDS) – a form of market insurance that investors can buy to protect themselves against corporate bond defaults – more than quadrupled last year to $2 trillion, covering a notional $58 trillion of loan debt.

The very size of all these numbers is just about enough to give the jitters to anyone, on the basis that when things can go wrong, they probably will.

When I wrote on this subject before, one respondent claimed that the topline numbers aren’t important because derivative markets are beautifully balanced. His theory was that if every derivatives position were hedging a risk relating to a specific transaction or asset, then derivatives would actually stabilise the world economy. All those noughts would be good news.

Sounds a bit too good to be true. And there are three reasons to be sceptical about this optimistic line of thinking.

Three reasons to be worried

Firstly, what we can call knowledge risk. That’s when derivatives players don’t know what they’re getting into.

A story on Bloomberg at the end of April summed this up pretty well. The chief finance officer of an Indian company was persuaded by his bank to start dabbling in the currency derivatives market. Although the CFO explained to the bankers that he didn’t understand how these products work, apparently they chauffeured him round and bombarded him with charts showing how his company could make a profit with a zero investment.

Too good to be true? Clearly it was. Three months later, two of the contracts had turned sour, incurring losses of $1.5 million and prompting the bank to issue a bankruptcy notice to recover the cash. Meanwhile, our poor CFO had no idea that these derivative bets could go so wrong. But he’s not alone. Indian companies could lose up to $4bn on derivatives, according to Hong Kong-based brokerage CLSA Ltd. Naïvety? Maybe. But we’re all good at repenting at leisure.

Which brings us onto the next potential problem, counterparty risk. That’s when the deal you’ve just done comes unstuck because the people on the other side of the trade can’t settle their side of the deal. A bit like backing the Derby winner, then finding the bookie can’t pay up because he’s run out of money.

Indian banks may lose up to $400m if they can’t enforce derivatives contracts they’ve set up with smaller companies, says CLSA. This is because 10% of these smaller companies may renege on their agreements because they haven’t the cash to settle the deals.

And this is just one country. BNP Paribas analyst Andera Cicione believes that total world CDS losses could hit $150bn. As the CDS market is unregulated, there are no public records showing whether sellers have the assets to pay out if a bond defaults. George Soros himself has warned this week that CDS counterparty risk is “a Damoclean sword waiting to fall.”

What’s worse – and here we come to the third problem – some buyers have now found out that the derivatives they’ve bought haven’t matched up to “what it said on the tin”.

The ratings agency Moody’s has just admitted awarding incorrect ratings to $4bn worth of debt instruments because of a bug in its computer models. Some ultra-complex derivative products, known as “constant proportion debt obligations” and thought up at the height of the credit bubble, incorrectly received over-optimistic triple A – i.e. top notch – ratings. And it took Moody’s nearly a year to find the problem.

As the derivatives market gets bigger and bigger, stories like these only make us ask: do the people who play around in it really know what they’re doing?

Source: Why Derivatives are Getting Much More Dangerous