Reflation Ahead In Early 2012 - But Not For Gold

by: Cantillon Blog

In my last major piece, written in May, I wrote that the focus in the eurozone ought to be less on lagging inflation. and more on prospective weakening growth, and favoured owning 2-5 year German fixed income outright, and vs UST. This has worked well, and it is now time to reconsider prospects for markets. (The piece below was adapted from a fuller piece written for another platform, and there are references to pieces not published on Seeking Alpha. If you would like copies of these pieces then please send me an email giving me some background about yourself).

I expect the new market dynamics to continue to wrong-foot many in the months ahead. I favor positioning on a time-horizon that is adapted to the natural frequency to which the market resonates. In the course of this year for German fixed income I have been bearish (from Oct 2010 till April 2011), bullish (May 2011 till Sep 2011), and bearish (currently) – and positioning on this kind of horizon has been the right thing to do. If one is at all oriented towards the deep fundamentals, then having a one-month view or having a one-year view must be nigh on impossible. (The typical length of a market move currently seems to be around four to eight months). So I have no grand list of trades for 2012, just swing trades that I expect to be attractive for entry over the next few days and weeks.

The general theme is positioning for reflation. I do not expect the eurozone to implode, but rather that growth will hit bottom and stabilize at a decent level in the coming months. The authorities have done a great deal, and have clearly credibly indicated their commitment to do a great deal more. In May 2011 I was criticized attacked by some for raising the possibility of domestic political obstacles to greater European integration – it is for now clear that I was right to raise those concerns, but that in the end the memory of Europe’s difficult history has strengthened the will of politicians to press ahead with unpopular moves, both for greater budgetary control in the periphery, and for greater political integration.

When a gun is pointed at your head, it is amazing the extent of domestic political reforms that can be achieved. The EMU is, after all, achieving what the leaders of the periphery had intended; it is a mechanism for importing sound governance into countries that have struggled to govern themselves. I suggested in July that in the longer run, to stabilize the crisis, the periphery would need to give up sovereignty over domestic budgets to the centre in exchange for a backstop from the core, and ultimately for the subordination – implicit or explicit – by the ECB of inflation targeting to funding stability. We are not quite there, but we are close enough that the crisis phase can for now come to an end.

Since I suggested in early September that we were in the terminal phase of the growth scare, we have seen growth surprise to the upside – in Europe, but also in the US and the rest of the world. This has been reflected more directly in some markets more than others, with in my view market positioning and psychology as much as fundamentals being responsible for the variation in outcomes. Since then, I have suggested favoring a buy-on-dips strategy in the equity market (noting especially the SMI and UKX), suggested that the time was approaching to start getting short fixed income, and continued to favor a buy dip strategy in the US dollar (a viewpoint established in May) but notably focused more on non-euro currencies such as the PLN, HUF, CHF, NOK and SEK, rather than wanting to be short the EUR/USD itself.

At this stage, every indicator of mass psychology that I follow suggests excessive gloom over prospects for the world economy generally, but especially for the Eurozone – I do not see these widespread fears as consistent with the prospective fundamentals. Specifically, concerns over both growth prospects and prospects for the EUR exchange rate seem to be cataclysmically negative in relation to the fundamentals as I see them. CFTC data points to speculative short positioning last seen c. June 2010, the last time the euro bottomed on terrible news. Furthermore, I have a very compelling technical case for believing that we are close to the optimal time to be entering contrarian positions.

I will elaborate further in a forthcoming note, but at this stage I would close at a profit my dollar longs. I would accumulate long EUR/USD positions, buy commodities (including copper), start to establish shorts in US, Japan and German 5 year fixed income. For the avoidance of ambiguity, I am not suggesting to play for a one month oversold bounce; I am expecting a rally in these markets of quite some magnitude, and one should therefore expect it to take some time to fully play out. So I would rather focus on lower-delta call spreads further out in expiry (3-6 months, and would prefer to err on side of buying too much time in markets where distant expiries are listed) than on buying short-expiry calls, expecting to achieve perfection in timing the move.

Brave tacticians could consider playing the short side of the gold market – this market has gone unsustainably parabolic, viewed from a longer-term perspective, shows an abundance of signs of excessive bullishness of mass psychology, and a turnaround from the despondent level of growth expectations will push up real interest rates and turn attention away from concerns over imminent defaults by sovereigns, which is likely both to reduce the attractiveness of, and need for, gold as a safe haven. I believe that US equities have very likely completed their underperformance compared to gold, and that on a three to five year horizon, equities should do very much better.

US equity markets are likely to continue to outperform emerging markets in coming years, but we could see a correction of their recent outperformance (we have been bullish since October), particularly if I am right about a reflation in commodity prices. So I suggest taking profits on the ratio trade, and focusing more on markets outright for now. I am not proponents of playing this move via commodity-producing emerging markets, but would note that sentiment seems very negative for both India and Vietnam, and that the technical picture in each of these markets starts to become appealing (completion of a clearer basing pattern being the missing piece).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.