The “risk-on” trade is back in full force today as portfolio managers and hedge funds are already behind the curve due to this year’s whipsaw market action. However, the need to performance chase is becoming critical as the inevitable tick of the clock slowly counts down the remaining days of 2011. All eyes currently focused on each and every headline that comes out of Europe and the myriad of possible outcomes has the markets on edge.
While the markets are currently ignoring the fact that Europe is already in a recession and most likely a very bad one, China is rapidly slowing economically and the U.S. has little capability to avoid any recessionary drag from its major trading partners; fund managers are going “all in” to try and make up lost ground by years end. With the markets pushing higher and once again wrestling with resistance from the first half of the year, as well as breaking out of the previous trading range, the mainstream media is ladeling the rich gravy of “bullishness” on top of the much anticiapted Christmas rally.
Even though that last week we pointed out the at the global intervention of liquidity that jolted the markets was not a panacea – the markets are currently betting on a “shock and awe” campaign from Europe Union. Just today French and Germany have come to an “agreement” on a new treaty for the Eurozone with stiff penalties for those that do not meet and maintain budgetary guidelines. If the Eurozone is able put together a plan to actually begin to alleviate the crisis and remove that threat from the headlines the markets could rally signifcantly from here.
For this to happen I would expect to see a coordinated effort by the central banks of the EU to aggressively act in coordination to:
- Cut interest rates (we will hear from the ECB this week)
- Allow members of the EU to potentially withdraw from the Union (ie Greece)
- Actually fund and leverage the EFSF to buy distressed debt from Spain, Italy and others to reduce market rates so these countries can roll their maturing debt.
- Provide additional levels major Quantitative Easing (even likely in the U.S.)
The markets would surge strongly in a relief based, liquidity driven, rally. However, it will be just that – a liquidity driven rally that will only postpone the inevitable as it does not address the solvency issue. Furthermore, the massive injection of liquidity in the system would ultimately only delay impending recession due to the deleveraging cycle. None of the issues being implemented to solve the crisis functionally address the two big issues that must be dealt with – solvency and excess debt.
My concern, however, is that the real “risk” in the market is that a “deal” is not reached. It was one thing to assume that logic will prevail and rational heads will do what is necessary. It is quite a different story in reality. Trying to get 17 parliaments to agree on very tough and unpopular measures will be difficult at best and nearly impossible in reality. There is a possibility going into the end of the this week that we will only have more delays and excuses. The market would likely be very disappointed in such an outcome and decline sharply.
This is at best a traders rally. A breakout above resistance at the neckline could propel the markets back towards the highs of 2010. Another dissapointment out of Europe and we could likely be testing lows just as well. There are times when inaction is the best course of action. The upside potential is mitigated by the downside risk of loss and for individuals looking at making longer term investment decisions – the best decision may be just to stand aside and wait to see what happens.
Our forecast for the U.S. in 2011 has not changed – there is a strong likelihood that a recession will set in, corporate profit margins will contract and the asset prices will decline. That is what the economic data is telling us currently. A bailout of Europe and additional QE here in the U.S. would certainly delay such a market decline as well as slow a potential recession. However, the reality is that as the debt deleveraging cycle continues, consumer’s sharp reductions in savings rates in recent months and the real employment situation much worse than the headlines – even another QE may have very little positive effect on the economy and the markets longer term.