Market Outlook: Unclear In Short Term; Down In The Long Term

Includes: EU
by: Jeremy Robson

I penned an article on the economy on June 18. The economic data, since that article, have all been weak. Hussman, Zerohedge and ECRI have all called recessions. For me, the data in the last 2 weeks is a little worse than expected, but it does not yet signal a recession. I had estimated that real GDP is between 1.5-2%. I would now suggest that growth will be around the bottom of that area at 1.5%. None of the data has yet hit a recessionary level. It would need to deteriorate further from here to signal a recession.

This is true of regional and national ISMs, industrial production, retail sales and the second tier data of tax collections, rail traffic, sea port containers and trucking volumes. None of the data is yet contractionary, but it does not leave a lot of room for maneuvering. On balance, I still expect that the 2012 budget deficit of $1.2-1.3 trillion will be enough to keep the recession at bay in 2012. After the presidential elections, I am not so sure of the fiscal position. It is typical to get the budget cutting done in the first year of a presidency and I do not expect this cycle to be any different. 2013 will be a difficult year.

This economic viewpoint comes with the enormous caveat that Europe does not break apart and cause chaos. On this point, I have no clear opinion. My best guess is that things will muddle along badly, but not fall apart. It is not an opinion that I have a great deal of faith in. Writers who give firm opinions on Europe are, in my opinion, irresponsible. It is impossible to predict the outcome in Europe with certainty and foolish to try. 'The outcome' that I refer to is whether the Eurozone breaks up, or moves to full economic integration.

Short term

I think that the 20th (or is it the 21st?) European summit will produce no meaningful agreement. It will clear up several points:

1. Euro bonds and a European wide bank guarantee will not be agreed. This will at last be recognised by the peripheral nations. Perhaps we will see an end to the public bickering over these issues (which will be helpful).

2. Germany, Finland, Austria and the Netherlands will resist any calls for further bailouts, unless they are accompanied by structural reforms. They have held this position from the start of the crisis and I don't expect that this will change. The periphery nations will have to start structural change if they wish to get further support.

3. There will be some outline of full economic integration. This will be a long way away from the present position. It will not include large scale concessions from the hard nations. It will lay out a framework for integration that gives the periphery nations a way to enlist financial support. The periphery will not like the conditions that it imposes on them.

3. The ECB will continue to hold back support to get the EFSF/ESM to be the buyer of last resort (until it runs out).

This sounds very bearish, but I am not so sure. We are presently in this position and nothing will have changed at the end of the summit. Will the market reaction be to panic or will we just carry on and assume that the authorities will act, just before Eurogeddon? This outcome seems just as plausible as a panic. The market has assumed a positive European outcome for the last 2 years. Will it suddenly change its collective opinion?

We are approaching quarter end and earnings are just around the corner. I could see the market at 1390 or 1290 in the next 2 weeks. I am bearish and hoping for 1390, for a good bearish entry point for some shorts. Technically, the S&P500 looks to be in a consolidating flag. The top of that flag is around 1388. If we were to approach this level, I will get a good trade entry point, with a tight stop at 1410, for a trade back to the lows around 1285. If the market breaks 1310 to the downside, after the summit, lower ground beckons (without a rally). I do not expect the second quarter earnings to provide a catalyst for a market move in either direction.

Longer term

In the longer term, I am bearish. I have thought since the middle of 2011, that more fiscal stimulus was off the table. I have expected that the market will fall, which it has not. Monetary policy has held it up. I do not expect this situation to last past the end of 2012. Monetary policy at the zero bound is weak. One QE that fails to stimulate the market is all that it will take to remove the prop. It continues to be my opinion that there is not the required political will to enact the size of monetary stimulus that is required to stave off a nasty recession. This would need to be massive and in the several (perhaps around $5 trillion) mark. Bernanke is stimulative, but I cannot see programs of this magnitude being enacted.

I would suggest that the recent closing double top at 1410 at the end of March will not be broken for some time. A large QE in July or August might do it. It is clear that the many problems that the world economy faces have not unwound yet. I am inching toward the view that large scale money printing is having a negative impact. It is reducing real disposable income and is not stimulating the economy in a meaningful way. The only remaining solution is even more fiscal stimulus (above the £1.3 trillion deficit), supported by Fed buying of bonds to keep the treasury yields at their present levels. This is Japan in the nineties. I cannot see this policy response at present (but have not ruled it out entirely).

Trying to predict the present market is all about figuring out the policy response to weak or recessionary growth. I am assuming that the recession that so many have called for will arrive in 2013 as the policy response will be some sort of fiscal slope. My present guess is that the U.S. will have fiscal consolidation of $150 billion for 2013. This will be enough to bring on a recession. It is just a matter of time until the market starts to price this in.

Additional disclosure:

Long RWM, RIMM, USD/JPY, various UK corporate bonds. Short EUR/USD.