Headless chicken to the short term bounce

As I have been telling friends over the last month, the markets will be more or less like headless chicken before the Fed meeting at the end of this month. I still think the Fed will likely do QE3, at this coming meeting or the next one, given how weak the US economic numbers are. The only problem is that the numbers are not bad to provide a complete political cover for QE3 yet. I would still suggest an increased exposure to risky assets before the Fed decision next week. However, the rally probably won’t last that long. It would be a good time to buy more LT T bond and set up shorts of equities sometime in the next few months.

Having finished a 7 stop 22 day trip to China, I realize that China’s current economic situation is much direr than the government headline GDP numbers or housing prices would tell you. There is still room for infrastructure; for example, most cities need subways, and a lot of them, and high speed rail could still expand in some segments so that the speed is really all high speed (i.e., 200 miles / hour). But the speed and amount of investment probably won’t create much growth from the already humongous investment level. We should have a little bounce (but not that strong, and certainly much weaker than 2009 bounce, as I predicted at the start of this year) in the second half. But the situation will likely to be worse next year and much worse the year after in terms of headline GDP numbers. China’s housing prices, stock prices, and many asset prices will be sharply lower in the next decade.

There will be no return

So the centralist won the Greek election, which will commit the country to unsustainable policy by default.  Even though markets cheer for now, which should not be too strong after the huge burst today given that the central banks have no clear reason to intervene, markets should understand this would set up the eventual exit of Greece from the Eurozone, and there will be no return from here.  Syriza will watch on the sidelines until the current government fails under the unsustainable policy.  With the economic deterioration and bank runs from now to then, as well as the return to primary surplus of Greece in early 2013, it will make the exit from the Eurozone a viable and attractive (in relative terms) option.  However, history has shown that the Greek exit from the Eurozone will set up the greatest investment opportunity in the last three years (rather than investing in bubbles in emerging markets).  I am dreaming about the day when Spain will fall out of the Euro bed ;=). 

Like always, if all the Central Banks are about to take out the big gun, follow the flow of the crowd

The crowd always listens and tries to start a party. This might be initially offset partially by the uncertain outcome of Greek election and the subsequent bargaining between Greece and Germany. That could set up the buying opportunities when markets dip occasionally. Or if you were brave enough to short since April, now is the opportunity to cover your shorts before markets go up a bit from here. Among the central banks, the U.K. is likely to ease soon. The U.S. probably will have to wait till July with only some Twist type of actions in June. ECB will stand by with some bond buying but a new round of LTRO will be a long shot. Maybe no market rally leading into Greek election would have been a better thing for markets; that way, we will get more stimulus, which sets up for a bigger rally.

But the Eurozone issue will come back soon enough, even if Greece is unlikely to leave Eurozone this year (and most likely the next year). It will also be even more difficult for China to hide the strong side effect of its imbalanced growth. By the end of this year, we probably will have another bout of shakeup when markets start to forget how painful it could be by being overly optimistic. To avoid some partisan accusation / perception, the Fed may not be as forthcoming if things start to drift down again before the election.

I forgot to mention that it has already been time to set up the pair trading strategies mentioned since last year

Too busy. Set it up until the Fed or China step in with large amount of stimulus. The ECB is probably on tight German leash right now after two LTROs. The deposits are flying the PIIGS countries, especially Greece. This happens every time EZ is under stress, and cannot be solved by LTROs. It will reach the point that one by one the silent bank run will make PIIGS countries being much better off to be out of the zone.

The market is starting to turn over

So it is a wise decision to sell in early March so far. That is if you have followed my suggestion. Some of my friends are still waiting to sell in May. Well, I hope they are lucky and I am wrong. Now the big question is whether company profits are starting to plateau. It is probably not as obvious at this point but as the earnings season unfolds, we will know more about it. I am not optimistic about earnings growth, but it is not safe enough by my standard to do naked short. So if you are brave enough, you might take some bets on the short side, especially on those benefiting big from the risk rally.

HK's future

HK really has to think hard to find its right place in a more open China, instead of waiting for Beijing’s implicit subsidies. Otherwise it would lose its future pretty quickly. The 20 some percent high school graduates entering college is extremely low and the 20% poverty rate is extremely high. The future might move past HK pretty quickly.

But the tycoons do not care, as long as they can keep paying no taxes on capital gains, from which they draw most of their income, while charging high prices on everything in HK, from which they make a lot of money.

• HEARD ON THE STREET
• Updated April 11, 2012, 12:02 p.m. ET

China Gets in the Zone for Luxury

By LAURIE BURKITT And TOM ORLIK

China's government departments are locked in a battle over whether to cut the country's luxury tax.

The Ministry of Commerce wants to drop a roughly 30% tax that drives shoppers to Hong Kong and Paris to buy their Prada handbags and Chanel sunglasses. The Ministry of Finance is suspicious of a plan that threatens to lower tax revenue. The outcome could be a boon for the luxury brands themselves.

One possible compromise is the creation of special luxury zones— urban centers where the normal high taxes are lowered. If that plan gets off the drawing board, the big loser would be Hong Kong, where mainland shoppers arrive in droves to take advantage of zero luxury taxes. Around 28.1 million arrivals from China made up more than two-thirds of the visitors last year.

Inbound visitors spent about 253 billion Hong Kong dollars (US$32.6 billion) in 2011, equivalent to 13.4% of gross domestic product. Queues of mainland shoppers outside Hong Kong's most expensive stores testify that a big chunk of that spending is from luxury tourism.

As a style center and shopping hub, Hong Kong is akin to China's New York. But losing its price advantage over mainland cities would hurt its retail sector. A downturn in luxury shopping trips from the mainland could have a meaningful impact on hotels and airlines as well.

The big winners would be the luxury companies. To be sure, the big brands have already established networks of stores in China, so a change in the tax regime wouldn't necessarily make luxury goods physically more accessible for Chinese consumers. Aaron Fischer, luxury expert at CLSA, downplays the impact of relaxing the tax laws. Chinese demand for luxury goods hit $46.9 billion last year, of which $27.1 billion was spent abroad; the main impact of lowering taxes or creating luxury zones would be to drag some offshore sales onshore, Mr. Fischer argues.

Still, the creation of luxury zones on the mainland would bring luxury goods closer to home for parts of China's rising middle class that don't want the hassle and expense of a trip to Hong Kong. More importantly, lowering the taxes gives the luxury houses an enviable choice for ratcheting up the profitability of their mainland businesses. They can lower prices and generate more volume or keep prices high and reap higher margins. Either way, they win.

 

Write to Laurie Burkitt at laurie.burkitt@wsj.com and Tom Orlik at Thomas.orlik@wsj.com