The first milestones in turning the tide around; still underappreciated by markets

The actions of ECB and the Fed cannot be underestimated. They are the first milestones in turning the tide around to help the global economy fight out of the Great Recession.  They effectively guarantee that deflation will not happen. More central banks, like Bank of England and Japan, will follow the steps. This is exactly what I have predicted when I said to turn around the bearish trade on June 15

 (http://xlpartners.blogspot.hk/2012/06/like-always-if-all-central-banks-are.html).

I hope you have paid attention and have not completely missed the rally.

By now, markets are still not fully appreciating the significance of these actions. So I have been out of the pair trading of buy S&P and shorting China related EMs a couple of weeks ago. I have gained max exposure to US small and mid caps, gold producers, Brazil, Spain, Thailand (hope no flood this year), and Norway. Even for S&P, there could be another 10-15% ahead to the end of year. I am also short long term T-bonds.

The ECB actions are implicitly supported by Merkel. Even though opposed by German voters, Merkel is likely to throw the implicit support to ECB before her reelection. To get reelected, ECB is the only institution that would provide enough firepower to prevent the collapse of the Eurozone, and German economy. After her likely reelection, I have hopes that she will be more explicitly supporting ECB. The negative news that would happen in the next few months will be the classical ones when one only relies on monetary stimulus but not fiscal ones. The peripheral economies could deteriorate further, and Greece probably will leave Eurozone next year.

The Fed actions are significant in the open-end nature of QE3, though if you track by blog, you would know that I still think it should come much earlier and in much bigger magnitude. By August 2010, I have argued for even more drastic actions

 (http://xlpartners.blogspot.hk/2010/08/future-intellectuality-of-stimulus.html).

Now we finally have some form of what I advocate, I would get out of long term T-bonds unless for some protections against events such as Greece leaving Eurozone. We are much less likely to have as dramatic risk on and risk off cycles from now on.

Is the coast all clear? Not really. Only having monetary stimulus is like fighting the battle with one hand. ECB in particular will need fiscal backstop of Germany badly to expand its bond purchases substantially. We may still have limited growth even though central banks have guaranteed that deflation will not happen. Further, Greek departure from Eurozone could still bring a lot of disruptions. U.S. fiscal cliff early next year could be highly disruptive even though its impact may have been exaggerated a bit. Maniacs (at least in rhetoric, and may be adopted to cater to their conservative base) like Romney and Ryan could still be elected (if they do, and if they implement policies they advocate so far, e.g., moving even slightly toward gold standard, it would be great time to leverage long term T-bond exposure and short equity big time).

Whatever will happen to the rest of the world, China, and the countries with big exposure to its growth model, will keep slowing down substantially from next year and on. Their equity markets will keep lagging or dropping until all the investors slowly come to terms of this fact. I expect the shorts to be set up late in the first quarter of 2013.

Some more legs for the markets

Have been quiet for a while. Partly very busy, partly due to the uncertain nature of the Fed QE. Having said that global central banks will start QE soon on July 27, which is positive news for the markets, it is very uncertain what they will do specifically. It is a good surprise that ECB has done QE in the form of vaguely defined unlimited bond buy for short term bonds of peripheral countries, which naturally boost up the markets. However, what ECB can eventually do will depend on their testing of boundaries under the resistance from Germany. Today’s employment news for the U.S. should substantially increase the likelihood of the Fed for further QE in September, which is likely the last chance that the Fed would do QE before the election. So there are probably more legs for the markets, even though the good news should have been fully prices; the markets always overshoot.

Why the markets did not tank today?

Some of my friends are asking this question. First, the Fed did build up even greater expectation that they will likely intervene soon. September will be the likely date; otherwise any later day would make Republicans blame Bernanke, who is a Republican, for helping Obama. This effect will hold the market for the next month so as not to completely fall out of bottom. Second, Draghi has built up high expectations of ECB intervention and has had some effect. They are expected to clarify tomorrow, but I am sure it will be some boilerplate stuff again when push comes to shovel.

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.