Markets in Pilgrim’s Progress or just Economic Great Game?

With volatility and uncertainty elevated, at issue is whether markets are reflecting the equivalent of a pilgrim’s progress or the economic version of the great game. Clash over economic policy between the United States and Europe is far from unusual but now positions appear reversed on timing reduced size of government. Despite the niceties at G20/G8 meetings in Toronto, individual policy requirements have changed ranged from pressures in Europe on sovereign debt, to inflation in fast growing Asia to fears in the United States that slowing again may be critical areas like housing and employment. Political angst appears in change in a year of three U.S. commanders for forces in Afghanistan, in five prime ministers in five years in Japan, in a previously unthinkable British coalition of Conservatives and Liberal Democrats, in an Australian Prime Minister overthrown by his own party over tax and challenges for China not over currency or Taiwan but domestic change in the form of strikes on pay and externally, North Korea. We would also draw attention not to Europe on currency but Japan with its size and engineering prowess where a strong currency but large deficits and debt may be placing global stress.

The financial sector is core to capital markets and misappraisal of risk was not its purview solely. Nonetheless, central bank policy change is likely to be slow with higher market sensitivity to the political economy, including financial regulation. Like information technology before, business realities now are likely to favor those financials (not just banks but also hedge funds and asset managers) addressing radical change, in advanced areas like Europe and the United States those that restructure deepest over those clinging to older business plans that emphasized momentum over fiduciary quality and in emerging areas like Asia and Latin America to favor those that build capital over those maintaining fast loan growth. For capital markets there has been binary change in May/June 2010 in equity price drops globally, in commodity prices decline with gold bullion holding up and eerily in U.S. Treasury and Japanese Government bond yields dropping as others rise in a shift from expectations of a 2002/7 like echo boom this time driven by quantitative/fiscal ease to a dash to fears of double dip into global recession. For political certitude and financial change reasons, volatility is likely elevated but not easily modeled mathematically. It has major implications in that many trading regimens, including high frequency, were developed during relative stability.

We believe benchmark yields such as U.S. Treasuries and Japanese Government Bonds need to rise before balance returns. Alternate hedge conditions of today favor precious metals and private equity over others. At 1047 and 1079 respectively, the S&P 500 and MSCI World index are at the cusp of our unusual value territory of 1050, versus 2010 respective peaks close to 1217 and 1218 and our trading range targets of 1100-1200, above which sustained gains are likely to have difficulty until mid 2011. At the cusp of Q2/2010 earnings reports, our S&P 500 operating earnings expectations of 75 for 2010 and 85 incorporate growth but below consensus which is likely to drop. The potential for a global recovery cycle of give and take favors quality. We underscore that market angst now has started to signal that trading dominance over the last fifteen months pushing the envelop upward, may now be giving way to conditions conducive for a different type investor to participate, focused on ferreting out value.

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