A Bearish John Taylor Asks If Too Much Fear Is Priced In

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One More Try for Risk
June 3, 2010
By John R. Taylor, Jr.
Chief Investment Officer

Troubles are everywhere, in the Gulf of Mexico, in Greece, and in Korea, to name just a few, but we already know about these problems. Other than the tragicomic opera being played out along the 38th parallel and in the waters around the western sea border, which is still lighting up our brain cells, the other news has been rehashed ad nauseam. The airwaves have been so full of Greece and the gigantic US oil slick that the rest of the world has been forgotten. In fact, the Greek problem has been ‘solved’ at least for a while. The ECB is on the bid for the dicey sovereign debt and all is getting quieter in the markets – even though we can’t quite yet believe it. And, no one will really be able to judge the effectiveness of the tax increases and spending cuts until September at the earliest. A mainstream bank just sent out a report arguing “Fiscal adjustment in the Euro area: so far so good.” Who are we –or anyone else – to argue with that opinion? Anyway it is almost summer, so most Europeans will be taking their extended vacation. All those speculators who are short the euro could start to get nervous as it climbs a bit. The BP oil leak is another issue, as the situation has gotten completely out of control. Some pundits are even clamoring for the US government to step in, throw BP out, and fix it - now. With what expertise? There is no IMF for this problem. Although this is a wild card impacting the psychological health of American investors and the electability of anyone associated with Obama in November, the imagined impact has become so negative that a solution could bring a spectacular feelgood rally. The probability of an outcome better than the bleak expectations is probably higher than 50%. Add that onto the Greek solution and this looks like the right time to bet on a risk rally. If only the North Koreans took summer vacations like the Europeans, it would be a sure thing.

Although our analysis argues that the global economy should be slowing down and starting a long
decline, the tremors that went through the markets in May have halted the Central Banks’ tightening drift, which should allow financial markets to rally again. The American fiscal stimulus might be losing its steam, but it is still positive through this quarter. Although this boost will disappear in the third quarter and will turn into a retrenchment by the end of the year, the US business community, as expressed in the ISM numbers and the local Fed reports, is positive enough to keep the economic naysayers (like us) on our back foot. China, the other global locomotive, is still gently applying the brakes and could prove the Achilles heel of our positive multi-month outlook. Too dramatic a slowdown in Chinese growth could prematurely chill investors’ enthusiasm, but we consider this risk a minor one.

The non G-10 economies, having suffered very little financial distress during the banking crisis of 2008, and benefitting from the current exceptionally low dollar, euro, and yen interest rates, are doing just fine. Adding this all together, it is possible to paint a very happy picture – as long as the looming solvency issues remain in the background. However, with banks cutting their asset sizes because they are short of capital and being hemmed in by new regulations, there is no way that multiple national debt restructurings can be avoided, but that is a story for the fall, or next year.

Our analysis of the long-term cycles points to a peak in the second half of July or August which would be followed by a long and increasingly dramatic decline that would continue into the middle of 2011 at the minimum. It is very likely that the global Central Banks will lower rates further, where they can, and will resort to increased amounts of quantitative easing. As much of the economic distress will be centered in Europe, the dollar will gain against the euro, but when the Fed eventually shifts into high gear – as it always does – the Asian currencies and maybe even the euro will outperform the dollar.

h/t Teddy KGB