"There is the school of thought, of which I am not a student, that believes we shouldn't worry about China and Europe since U.S. GDP is not overly reliant upon either Europe, 2% of total U.S. GDP, or China, 0.6% of GDP, but given that our economic revival is not particularly robust, any potential hit to growth has to be regarded seriously. And it is the strengthening domestic economy, abetted by perhaps misplaced optimism on the global economy that overshadows the current weakness abroad."
Like most, I tend to operate from selective memory. Sometimes I have to venture far into the archives to find a pearl of wisdom, other times the proverbial ink has yet to dry. Fortunately, this occasion finds me in the latter camp leading to a trip back to March 6th. I actually present this somewhat cheekily since the S&P has had a nice move since the date I wrote the above, but completing the thought, I remained bullish equities within a much reduced net long position, laboring under the belief the non-US swoon would not really hit our economy until year end. That is still the case from an economic standpoint. It shouldn't be a surprise to anyone that the massive credit issues in Europe have caused a slowdown, nor should anyone be surprised about China, where economic indicators have revealed a contracting economy for 4 months. However, with the market being a discounting mechanism, perhaps I was too optimistic. I went on to say:
"To bottom line it, the market is in a consolidation phase and faces the likelihood of a minor correction near term while remaining highly dependent upon data in the U.S. and continued optimism about the European and Chinese economies."
This will update my outlook and clarify my views. The market is in a consolidation phase with a slight bias to the downside in the very near term as we are in a good news vacuum pending earnings. Optimism still reigns regarding China's ability to manage their way out of their declining economic fortunes; and the yields on sovereign debt in the countries that matter, while recently forfeiting some of their optimism, are still at much more reasonable levels. The key factor going forward will now be earnings season, which I suspect will acquit itself well in most areas of the economy except for certain sectors, such as coal and steel, where I have been very visibly short, and which have already updated their outlook. (Every steel company, regardless of business model, has disappointed but has guided to a turn in fundamentals resulting in a nice move off the bottom. I am still short. And coal remains in a death spiral.) This will provide support for the market at that juncture but for now, in a good news vacuum, the path of least resistance is slightly lower.
But the key to a further rise in equities is the direction of US government bonds. While flows continue into bond funds in a meaningful way and out of equities in a less meaningful manner (a situation that surprises me), I believe this will reverse. I am short through TBF and TBT because I believe most investors have come to expect unabated and unprecedented performance and don't realize that a an 85 bps back-up in yield from 2.15% to 3% will result in approximately a 7% loss in capital, an untenable risk/reward when considering that any appreciation of Treasuries is, in the best case, severely limited. And as the EU sovereigns continue to hold these levels, funds will flow from bunds and bonds into their higher yielding debt.
Within the slowing of global growth view, I remain short the Euro and Aussie dollar and materials, and long technology, big US banks, and defensive value. The market will continue to pause, but not collapse, into earnings season, and unlike each of the other reporting periods since the bottom in March 2009, expectations are much lower, setting up for decent equity performance for the next quarter unless sentiment regarding Europe and China fall off a cliff. I realize this straddle risks my being likened to a sell-side strategist (a label more feared than "moderate Republican") but that's how I see it.
Additional disclosure: I am short FXA but all positions can change without notice.