The Rally Is Ending
July 29, 2010
By John R. Taylor, Jr., Chief Investment Officer
For FX Concepts, this is a big day and a very scary one as well. Because our market view is now very precise, but at odds with the accepted wisdom, we are putting ourselves out on a limb. The euro is going to be hit again and commodity currencies will come under increasing pressure. Our cyclical analysis argues that the currency markets are making a major reversal right now, today, and that this will be at least a medium term reversal in equities and credit as well. Although it is more likely that the equity and credit markets will not begin their major decline until the last week of August, the odds favor an unimpressive month ahead which means that we are at the end of the exciting part of the rally of the past two months. By the end of next month, equities will be headed lower, credit spreads will widen sharply, and government bonds will begin a rally to new all time highs. Our completely technical cyclical work implies that there will be a return to dark times in September and October, with a sharp decline driven by liquidity and solvency issues likely to set the world back on a recessionary course.
Although the cyclical picture gets more uncertain the farther out we go, we believe that there will be a major cyclical low in risk during January and another one, possibly more aggressive in the third quarter of 2011.
Using this cyclical analysis as our base, we can work backward to generate a set of fundamental conditions that would allow a cyclical picture like this to occur. If the S&P 500 is going to challenge its March 2009 lows in the next year, and interest rates are going to drop sharply while credit spreads widen dramatically, what would the US economy have to do and what would the world look like? Clearly the widespread conviction that the 2008 recession is in the rear view mirror and that growth will slowly improve in the years ahead is wrong. All the forecasts of the G-20 governments are completely off base, which means that the politicians are not prepared for another downturn. We wonder what the downturn will do to the Eurozone, the US, China, and Japan, as each one is vulnerable in a different way.
The financial underpinnings of the Eurozone do not look as though they can tolerate a recession in the coming year. The recent stress test has shown that an economic decline would be disastrous for the banks. Even though the test was easy, only marking down the small fraction of sovereign debt held in the trading accounts, among other things, many of the banks still had low tier one capital ratios. If even one Eurozone government finds itself unable to roll over their debt, the whole system will come tumbling down. Our cyclical picture means that we must be negative on the outlook for the euro, and the odds favor some significant euro restructuring during this next year. A recession in the US might imply a collapse in the municipal market as many states and lesser jurisdictions will find themselves forced into bankruptcy, but the banks and the major corporations are more liquid, and therefore stronger, than their counterparts in Europe. The more aggressive write-offs in the US and the coming municipal bankruptcies are accelerating the deleveraging of the US in comparison with that in Europe.
So, it is possible that the US will come out much stronger in the next few years. A slowdown in global trade similar to that in 2008 will hit the Far East countries, especially Japan and China. As the cyclical picture is projecting a decline similar to that of 2008, it is reasonable for us to assume that the credit markets will seize up as they did then and that the economies will follow roughly the same course. We will be carefully turning our positions in the direction of a stronger dollar and a stronger yen just like we did in 2008. We are bullish on government debt as well.
h/t Teddy KGB