John Taylor On Why "The Ground Is Not Solid Beneath Our Feet"

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The Ground Is Not Solid Beneath Our Feet
May 10, 2012
By John R. Taylor, Jr.
Chief Investment Officer

Investors should be questioning their positive assumptions after the events of the past two weeks. Things have changed a great deal and rumors abound on how the authorities plan to support the market now. At the end of last month, only ten calendar days ago, the perky US equity market, the placid foreign exchange scene, calm credit spreads and rock-bottom volatility implied to us and anyone paying even cursory attention that the world was happy with the way things were turning out in 2012, no matter what the Mayan calendar might be saying. But now, after the Socialist victory in France, the Greek electoral disintegration, the poor US employment numbers and the disastrous European PMI readings the market is very uncertain with the EUR/USD below 1.30, Spanish 10-year Bonds back over 6.00% and equity markets down sharply around the world. Our cyclical analysis finds this weakness very appropriate as we should be in a decline. A look back at the letters of the last two weeks will give you a hint as to our state of mind. I am clearly worried that we could be at the start of a serious meltdown in the global markets, not the same as 2008 and not like the flash crash of 2010, but perhaps incorporating some of the characteristics of both. At the same time, as a manager of corporate risk and an absolute return manager, I have to be ready for the government intervention that is sure to come. As you might guess, we are not too optimistic about the Eurozone authorities’ chances of final success, but the bad news will continue and eventually they will do something dramatic. The road to hell is paved with good intentions of governments, but they make for a volatile ride. We know we will be wrong on many counts, but our function as analysts is to lay out our view of the next few months, so here it goes:

We still believe Barack Obama is not likely to be re-elected this November as US unemployment is much more likely to be above 9% rather than below 8%. Although the US economy far outperformed our expectations during the first quarter, nothing has changed and 2012 will be a recession year with the Eurozone registering terrible numbers far exceeding what the market seems to expect. Our estimate is below 2% even counting a generally flat performance in Germany. The real issue is Europe, not the US or Asia, but the drag spreading from its weakening banking structure will impact global trade and the animal spirits of the entire world. The picture is bad, but our cyclical work implies the global markets should bottom in – or risk will be off through – the period between September and November. The ferocity of this decline might be muted dramatically if the European authorities can figure out a way to minimize the North-South divisions that are tearing the Eurozone apart.

What makes the ground so uncertain beneath our feet is the reality of our current position: interest rates are at zero, fiscal budgets are stretched to the maximum, total national financial liabilities are at a breaking point and national monetary bases are a multiple of the highest they have ever been. Quite simply, there are no good borrowers. No one wants to loan anyone any money. Fiscal consolidation must be carried out, and that tends to mean recession and loss of wealth, which will negatively impact financial markets. Although this can theoretically be an orderly process, the most likely course is not a fair parceling out of pain, but a frantic protection of selfish interests in which those with the upper hand will punish those that are weak. Currently, the crunch is focused on Greece and the other indebted Eurozone countries, but their agony is almost certain to radiate throughout Europe and the world, unless they are given a kindly helping hand. Unfortunately, we are almost certain this will not happen. Not the IMF, Bernanke’s QE3 or any BRIC miraculous assistance will put this issue right, and the risk-off fervor will take global equities down, stop global credit growth and strengthen the dollar.