Ball Of Confusion: Trading The U.S., China And The Eurozone

by: Plan B Economics

The world today is - as it always has been - a "ball of confusion" (to quote the 1980s pop group 'Love and Rockets'). I'm about to simplify it for you. Of course, I could be totally wrong and my thoughts today won't necessarily be my thoughts tomorrow, but that's the nature of a dynamic, integrated global market.

Let me start by explaining that nothing moves in a straight line. In fact, today we are trapped in a market cycle that seems to repeat every 6-12 months:

  1. Markets tank and pessimism reigns

  2. Central banks step in and add liquidity

  3. Markets improve and confidence improves

  4. The expectation for ongoing central bank support declines

  5. Markets tank and pessimism reigns

As you can see we are in a catch 22!

Running parallel to this monetary-linked catch 22 are economic fundamentals. Like an ocean undercurrent, the flow of fundamentals is all-the-while moving in a consistent direction. The fundamentals will play tug of war with monetary and market schizophrenia, but eventually the catch 22 will be busted. Fundamentals always eventually win. (Of course, "markets can remain irrational longer than you can remain solvent". -John Maynard Keynes)

Below I discuss how this ball of confusion, as it relates to policy and fundamentals in U.S., China and the eurozone, can potentially be traded:

1. USA: Crawling out of a Big Hole

The U.S. is slowly recovering from a painfully sharp economic contraction. While the data (unemployment, food stamp use, housing) remains bleak, it is improving at the margin. And that's what matters. Marginal changes in home prices drove the economy down over the last few years and it will drive the economy up again too. Case-Shiller Index data released recently shows that U.S. housing is recovering, with prices up 2% year-over-year.

The U.S. has a big hole to climb out of, but stable-to-improving housing data will help build personal financial stability and wealth. Home ownership is on life support, but the rental market is thriving and institutional investors are noticing. A reviving property market has a trickle down effect on jobs and durable goods purchases, impacting many areas of an economy.

For example, families buying homes today can lock in 30 years of fixed expenses at a historically low rate. This too promotes long-term stability and gives the family the ability to purchase other goods and services.

In fact, we're already seeing gradual improvements in consumer sentiment and corporations are more profitable and cash rich than ever.

The big question for the U.S. is if these marginal developments can have a lasting affect on aggregate wealth. Historically, broad wealth creation and standard of living improvements have been linked to innovation, such as the railroads, the personal computer or the Internet. And these innovations can be linked back to resource discoveries (such as coal and oil) that gave us the cheap energy to vastly improve productivity. So the question is this: Can the improvements in the U.S. (and global) economy last beyond the next few quarters? And what impediments are there to continued improvements (e.g. fiscal cliff)?

Growth or no growth, I suspect the Federal Reserve will aim to suppress bond yields as long as possible. The Fed has chosen employment over inflation and may be covertly inflating away the American debt crisis. Of course, this leads us back to the catch 22 explained earlier.

Watch your entry points and try to hold out for the inevitable fear-derived corrections. Personally, when opportunity arises I may buy income producing assets such as iShares iBoxx $ High Yield Corporate Bond Fund ETF (NYSEARCA:HYG) or SPDR S&P 500 Dividend ETF (NYSEARCA:SDY), or a broad-based equity ETF such as SPDR S&P 500 Index ETF (NYSEARCA:SPY). Traders may want to move in and out of these assets, but I plan on holding until it no longer makes sense, given my personal risk profile.

2. China: Locked and Loaded

Hard landing or soft landing? That's the trillion dollar question.

A hard landing would likely cause a global recession and collapse in commodity prices. The case for a hard landing is strong: Property bubble, tons of bad loans, pressure on margins, weakening trading partners (i.e. The EU).

In contrast, the case for a soft landing is even more convincing: China has the economic and political firepower to combat a slowing economy. China doesn't have to run things through Congress, total debt-to-GDP leaves tons of room for fiscal stimulus and command control over the banking system means monetary stimulus can be extremely effective.

Just look at the speed at which China implemented a massive fiscal stimulus program during the 2008/2009 collapse (the long-term impacts of which are still subject to debate). Frankly, the money may have been better spent - China now probably has overbuilt capacity - but it did provide a big tradeable opportunity that lasted into 2010. Speed and blunt-force policy is the potential benefit of a command economy and investors need to harness this benefit to their advantage.

Looking beyond short-term blunt-force policy, China has also proven to take a strategic lead in the long-term development of its economy. And it has the political and economic structure to make policy decisions that look beyond the four year election cycle found in typical democracies. Some analysts even argue that today's Chinese overcapacity is the scaffolding for tomorrow's economic growth.

The Shanghai Composite Index is down about 15% over the past year and remains about 62% below its 5 year high. Fear over tightening margins, stimulus withdrawal, monetary tightening (to combat inflation) and a hard landing have all been drags on Chinese stocks.

^SS000001 Chart

^SS000001 data by YCharts

Of course, it is quite possible the Index declines further, but some analysts argue that Chinese stocks are overcompensating for a worst case scenario that will never happen. If one is to believe this, it could pay to hold Chinese equities (iShares iShares FTSE/Xinhua China 25 Index ETF (NYSEARCA:FXI)), Chinese bonds (PowerShares Chinese Yuan Dim Sum Bond ETF (NYSEARCA:DSUM)), Chinese real estate (Claymore/AlphaShares China Real Estate ETF (NYSEARCA:TAO)) or Chinese dividend paying stocks (WisdomTree China Dividend ex-Financials Index ETF (CHXF)). One might even consider indirect investments like commodities (PowerShares DB Commodity Index Tracking Fund (NYSEARCA:DBC)) or exporters to China (iShares MSCI Japan Index Fund (NYSEARCA:EWJ)).

3. eurozone: The Paradoxical Game of Chicken

The eurozone is playing a game of chicken with its largest member, Germany. But Germany and the euro are inextricably linked.

If the euro fails, Germany fails. Why? Because a dissolution of the euro would send the re-instated deutchmark to the sky relative to many of its trading partners (many of which are within the eurozone) killing German exports, the lifeblood of the German economy. Because of the turmoil in Europe caused by the periphery members, the euro has been suppressed making German exports more competitive. Remove the periphery (via a dissolution of the euro) and those left standing become much stronger, causing their currencies to rise.

The eurozone may be years from a permanent solution (fiscal union), so the ECB will continue to apply monetary salve liberally. To keep the strong countries strong, the ECB will continue to support paper issued by the weaker periphery countries in order to keep the union intact. Despite its political rhetoric, the alternative is unacceptable to Germany. The end result may be a pared down union, but the major eurozone trading partners will be remain.

While smaller eurozone members like Greece and Ireland might be sacrificed to help preserve the euro, larger countries will be defended. Specifically, the largest PIIGS member - Italy, which is the 4th largest eurozone economy - must remain in the union for it to be viable. Large internal trading partners cannot leave the eurozone if it is to be a viable trading zone (and if Germany is to remain a competitive exporter).

While I'm not a secular European bull, I believe a trading opportunity exists to add risk when Italian bond yields rise above a threshold that triggers an ECB response. Let's call that threshold 6%, but in all likelihood it is a moving target that is dependent on other dynamic fundamental variables. Regardless, if one is to assume the ECB will support the euro no matter what it, is reasonable to expect it to support Italy no matter what. Consequently, future Italian fiscal crises may prove to be entry points into the European stock market (DJ EURO STOXX 50 ETF (NYSEARCA:FEZ)).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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