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Government Infected

By Jay Pelosky

The economic and investment outlook for the second half of the year is rocky.  The European debt crisis, U.S. fiscal woes, and inflation in emerging economies remain a problem, and in some cases have taken a turn for the worse. Risks are rising of a major drop in stocks and possibly bonds (resulting in rising yields). The implication could well be a shrinking world economy.

There are two critical issues today: One is the increasingly active role of governments in financial markets, which undermines risk appetite. The second is the rapid spread of “sovereign infection” as investor concerns over sovereign debt levels infect core European countries and possibly the U.S. More and more, it looks like these two problems could combine, and calculating that risk and its economic and market effects is one of today’s main challenges for policy makers and investors.

Many investors feel lost in today’s financial world as government interventions have upended their investment process. Figuring out the chances of a Strategic Petroleum Reserve deployment, the effects of the European Central Bank debt market intervention or any of the numerous other market interventions have led many to step aside.

As these investors flee, liquidity declines. This is particularly true in the equity space where in the U.S. trading volumes in the second quarter were down 31% year on year. A lack of liquidity in turn generates volatility, which further reduces risk taking and increases the chances that a sharp price break could occur.

But is there a chance for the opposite—could financial markets experience a sudden move upwards? Some argue that much of what is worrisome about the world economy is known to investors and already reflected in the price. But while positive news can create rallies, true resolution to the issues seems unlikely—especially when it comes to dealing with sovereign debt.

The spread of sovereign debt infection is a direct result of the extend and pretend strategies  employed by governments on both sides of the Atlantic since 2008. In Europe it has been a case of failing to deal directly with the debt woes of the periphery, especially Greece. In the U.S., it has been the decision to link the debt ceiling issue to the budget debate that has left the country vulnerable. At the moment, infection is most visible in Europe, where because of political dithering, it has spread to core EU members Italy and France. Italy, home to the world’s 3rd largest bond market, faces significant rollover risk in the next few years as hundreds of billions in prior borrowings come due. France is afraid that more bailouts will cause its AAA rating to fall, making borrowing money more costly.

Debt transmission from sovereigns to banks and back again now threatens to spread to the U.S. through two channels. The first is the sad display of political theater taking place in Washington DC where the two parties have held loaded pistols to each other for weeks on end. If the U.S. Congress can’t control their trigger fingers and the U.S. defaults, no one really knows what will happen to the markets if U.S. sovereign debt is no longer considered “risk free.” Protecting against that possibility while determining where that money might go are two main challenges for investors. U.S. banks, still trying to work out of their own debt woes, must now confront their exposure to French and German banks.

The current situation—though unsustainable—has worked to Germany’s advantage. Maintaining Greece, Portugal, and Ireland on life support keeps a lid on the price of the Euro. Some suggest that a Euro shorn of its poorer members like Greece would trade closer to 2.0 to the U.S. dollar as opposed to 1.40 today. If this happens, Germany’s exports would plummet. It’s no wonder why they’ve allowed this charade to continue, but the game is drawing to a close. Greece will almost certainly default. The main question is whether it will be orderly or disorderly. In the end, it’s likely that the European Central Bank will print massive amounts of money, dwarfing the cash infusions by the U.S. Federal Reserve. Such money printing is likely to lead to a much weaker Euro, which is why Germany will support it.

The effects of a world filled with worried investors, capricious government interveners, and a rapidly spreading case of “sovereign infection” are simple: low returns and high volatility. In the U.S., the chance of default is not trivial. The delay in reaching a deal has only increased the prospects of the US losing its triple-A rating.

The corporate sector, however, continues to post healthy gains, and so high-grade corporate debt could become a safe haven for investors.  Other areas of opportunity include U.S. dollar denominated emerging market sovereign debt, which offers good balance sheets, high yields and municipal debt issued by states with a heavy manufacturing presence that should benefit from an expected rebound in American manufacturing.

Of course, the most likely scenario in the U.S. is that Congress lifts the debt ceiling without significant fiscal reforms until 2013. Should a deal emerge that includes sizeable spending cuts then bonds would be a good buy as cuts reduce growth and the chances of inflation. For the same reasons, such a deal would be equity bearish. The bigger the spending cuts, the more bullish one should be on U.S. Treasuries, especially ones with 20-30 year maturities as they offer the most exposure to a slowing US economy.

The U.S. equity market has been resilient with an S&P index hovering around the 1300 level though volatility is increasing. Earnings remain a key support, and the chances that earnings in the second half of the year could disappoint are the on rise. Earnings disappointments, combined with a lack of investor commitment, could quickly pull the market down towards to the 1050 -1150 level.

Given this situation, commodities, particularly energy and agriculture, continue to be appealing as long as the inflation fight in emerging economies goes well.

There is a silver lining to the whole situation. Emerging economies seem to have incorporated currency appreciation into their inflation fighting tool kit. This is good news as it reduces the risk of excessive rate tightening and subsequent hard landings. The greater the foreign exchange appreciation in emerging economies, the more likely world’s economy will grow. It protects the only source of sustainable demand: the emerging world’s consumer.

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Jay Pelosky is the founder of J2Z Advisory LLC, an investment strategy consultancy, and a board member of the World Policy Institute.

[Photo courtesy of Flickr user Daniel*1977]

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