It is stunning to see the relative calm of the world whereas very dark clouds are quickly gathering above our heads. As if summer holidays could excuse it all. Nouriel Roubini is announcing a "perfect storm in 2013, worse than 2008." I am not sure we will have to wait till 2013 to see it unfold. Here are three charts that in our opinion summarize very well the gravity of the situation.
1) European divergence continues:
Earlier this year, John Paulson, the notorious hedge fund manager, started shorting German bunds with the expectation that Germany would have to take on its shoulders large amounts of obligations (PIIGS debt). After the summit of the 28-29th of June, for a few days, there was a feeling that Germany finally blinked and that the Paulson trade was on. But now, the bond market is saying another story: the divergence between German and Spanish/Italian bond yields has been restored as if nothing happened. Spanish 10 year bond yields are back to the 7% area. At this pace, Italian 10 year bond yields will also soon be back at 7%. In addition, there is no new LTRO and no active ESM. Until the yields on German bunds start going up (aka. the final contamination of the euro core), we are still in the break-up mode and market forces will continue relentlessly tearing up the euro zone. During a recent press conference, Mario Draghi was asked: "what happens if Italy also needs aid?" His answer was symptomatic: "what happens if everybody needs it?! It's a…it's a big question."
Figure 1. Yield comparison of 10 year government bonds of Spain, Italy and Germany. (click to enlarge)
2) China and the US are slowly going downhill:
Chinese and US consumer price indexes peaked somewhere in the middle of 2011. Since then, we have had a very worrisome progressive decline. The fact that inflation is going down in the world's two biggest economies indicates that deflationary pressures are very strong. The further this trend goes, the higher the likelihood of an economic contraction. There are many other signs that these economies are slowing. We can mention the recent negative ISM numbers in the US and falling imports in China. Operation Twist extended or interest cuts in China are clearly not game changing events at this stage. Massive stimulus is needed both in China and the US to change these trends.
Figure2. CPI (YoY) of the US and China. (click to enlarge)
3) Emerging market stocks are on the brink:
The MSCI Emerging Markets Index ETF (EEM) displays a beautiful head and shoulder pattern. It is really very difficult to imagine how this chart could go up, but of course anything can happen. This chart shows that we are currently at key resistance levels, and once broken we might witness a very strong acceleration to the downside. Gold, another key metric, also suggests that something very serious is going to happen soon.
Figure 3. iShares MSCI Emerging Markets Index Fund ETF.(click to enlarge)
In summary, the situation seems very dangerous at the moment and we recommend our readers to carefully position their investment portfolio in order to avoid getting trapped in a massive and sudden sell-off. Leveraged positions should be minimized. Large positions in technology stocks and other non-defensive stocks should be reduced, hedged with options or closed. We do not recommend gold or silver at this stage. Getting into bonds does not seem to be recommended since they are very expansive at the moment. Increasing the cash portion of the investment portfolio might be wise, with obviously the main component in US dollars. For riskier players, shorting at the right time some specific risk assets can be considered: for example, the Australian dollar might greatly suffer in a risk-off environment.