Inside today’s Daily Journal…

The DEFCON system was created in the 1950s, during the Cold War.

It is a five-level scale that defines how ready our armed forces must be for a nuclear conflict. It’s based on an inverse scale (1-5) with the lowest number (I) indicating that nuclear war is imminent and the highest number (V) indicating no current risk.

For today’s purposes, I’m using the same scale to define the risk we face of a major financial markets (equities and bonds) collapse. And there’s a reason.

The U.S. military went to Defcon III in October 1973 during the Yom Kippur War. That’s when OPEC embargoed oil, prices quadrupled, and the original stagflation nightmare began. The first oil shock removed roughly 7% of global oil supply. Crude prices rose 4x in a matter of months. U.S. consumer price inflation went over 10%. And the S&P 500 fell almost 50%.

If the Strait of Hormuz remains closed, the damage to the world’s economy will be much worse this time. Today, roughly 20% of the world’s daily oil consumption – over 20 million barrels a day – moves through the Strait. When that chokepoint is intermittently closed by mines, drone strikes, and tanker attacks, you aren’t talking about a symbolic embargo. You are talking about a corridor that carries nearly three times the share of global supply that was disrupted in 1973 being physically closed to all shipping – including fertilizer.

The difference this time is that the entire global economy is built on just‑in‑time supply chains and massive financial leverage.

In the 1970s, we had inefficient cars and long lines at gas stations – but industrial inventories and domestic production gave the system a little cushion. Today, utilities, shippers, and refiners run much leaner. A 10- to 20-day disruption to 20% of seaborne oil flows and a double‑digit percentage of global liquefied natural gas (“LNG”) exports can push electrical prices, diesel, and aviation fuel up 30% to 50% in 90 days.

And that’s not the only problem. Stagflation isn’t merely higher prices. It’s the combination of much higher prices with much weaker economic growth. In Keynesian economics, this outcome isn’t possible. In real life it is the Achilles heel of the global financial system.

In the U.S., credit is collapsing at the same time that government deficits are reaching massive, unsustainable levels. That’s going to starve the economy of credit over the next year. As bad as the coming inflation seems, it’s actually the credit market that’s the real problem.

After a decade of 0% interest rates (which encouraged borrowing), household balance sheets are carrying record nominal loads of credit‑card debt, auto and student loans, and buy‑now‑pay‑later balances.

Delinquency and default rates have risen across the board: credit‑card delinquencies have pushed back through prior‑cycle highs, auto-loan delinquencies are climbing, and subprime borrowers are seeing double‑digit default rates again. We know from Google searches (“mortgage payment help”) that mortgage defaults are going to continue climbing as well.

Then look at private credit – the market that almost everyone still calls “alternative” even though it has grown to be a major portion of the credit market.

We are now dealing with something on the order of $1.7 trillion to $2.0 trillion in private credit globally. That compares with roughly $1.3 trillion in subprime mortgage balances in 2007. In other words, the private‑credit complex today is larger in nominal terms than the entire subprime market that triggered the 2008-09 crisis. And it’s collapsing.

Default rates in private credit have moved up into the high single digits – around 9% on some benchmarks. If refinancing windows stay shut (because of rising defaults and higher rates), and earnings continue to soften, these default rates will peak between 18% and 20%. On a $1.7 trillion to $2.0 trillion base, a 9% default rate is $150 billion to $180 billion of stress; 15% to 18% is $250 billion to $350 billion.

What made 2008 dangerous was not just the size of subprime mortgages. It was the leverage and opacity layered on top. Remember the entire alphabet soup of leverage on leverage: CDOs, SIVs, CDO-squared? Private credit has recreated that environment in a different wrapper: funds borrowing from banks to lend to companies that public markets don’t want to finance, using covenant‑lite documentation and payment-in-kind (“PIK”) options – all structures that encourage risk‑taking.

This corporate loan debacle is unfolding at the same time that commercial real estate faces an existential crisis in office buildings and a huge wave of defaults in multi-family housing.

The stress is now visible in the plumbing. Large banks are marking down their exposures to software‑backed private‑credit loans and are cutting advance rates on those facilities. Big private‑credit vehicles at bulge‑bracket firms and specialist managers are seeing quarterly redemption requests equal to 10% to 15% of their shares outstanding, and they are responding by gating investors (limiting withdrawals) – honoring only 5% to 7% and deferring the rest.

That is exactly how 2007 looked in real time: first you see a few “gated” funds and “temporary” halts of redemptions, then you see forced selling of whatever can be sold, then you see widening default and loss‑given‑default numbers that retroactively validate the marks.