The cross and the switchblade ...

Erik Nel, analyst at Atlantic Asset Management writes that that markets could not be more delicately poised at present, even if they tried, with a key technical formation (the “dark cross” **) on the S&P 500 implying that the market gods may be calling for their bearish pound of flesh.

However, these are early days yet, and while we are almost chuckling at how all of a sudden the world seems to be warming up to a double dip scenario this late into the slowdown, it is important to appreciate that the unevenness of the global economic recovery should not require a one-size-fits-all exit the way it was required going into the 2009 global recession. (And by the sound of things, as suggested by our Finance Minister.)

India is yet another case in point where a hike broadly against expectations last week pointed to some risks to the emerging market inflation outlook, while Brazil seems to be the poster child for the EM recovery at present. With the political change of guard in Australia likely to see policy fine-tuning held back slightly, the all-fall-down scenario now being sketched by all and sundry warrants some closer investigation.

We have been on record as early as February 2009 calling for a likely double dip, or at best a w w w-shaped recovery. This was predominantly premised on the fact that a combination of a balance sheet recession (annuity driven income takes time to swing from spending to saving and recovering losses) and just-in-time inventory could lead to wild swings between optimism and pessimism. Furthermore, we argued that while a double dip recession in the context of economic history was indeed a very rare phenomenon, the fiscal largess of especially our developed market brethren could lead to unintended consequences if not kept in check.

In saying all of this though, we like being part of the ‘fat part’ of the trade. This is why we called trading the upside adjustment to the most bearish GDP forecasts at the start of last year as a key opportunity, as we did trading the adjustment to the most bullish forecast on GDP at the start of this year. This shift now seems to have worked itself into the system, and in fact we have seen the first signs of downward adjustments to the most bullish 2010 GDP forecasts. This seems to be a global phenomenon with some of the more bullish global houses also appearing to be getting a bit nervous about their 2010 GDP forecasts, especially so for the US.

We feel what is necessary is to weigh up governments’ ability to stimulate economies further. In my previous life I authored a piece focusing on the speech that made Ben Bernanke famous in 2002 where, as an expert on the 1930’s Depression, he mapped out a course to avert this most dire of economic outcomes. It is from this speech that he earned the (in)famous “Helicopter Ben” nickname. My focus at the time was on his thoughts on capping Treasury yields in particular.

How do we tie this back to local markets though? While some prominent names have argued that the deflation/inflation debate is grossly overhyped, we would take a slightly different view. It is blatantly obvious that demand-side is dead or as close to dead as a sloth is before the sun rises. Margin squeeze, while late in the cycle, is probably still to take its toll in the local economy, and this will also have consequences on the earnings front. However, the world’s amount of effort cannot change the fact that the South African economy is faced with gigantic headwinds. And these are structural impediments to our progress.

In the short-term, what is clear, is that while fiscal and to a large extent global monetary policies are highly stimulatory and almost by derivation risky-asset-friendly, while also a positive in the cost of capital exercise, distortions in the global economy becomes even starker.

With SARB governor, Gill Marcus, emphasizing yesterday that the global recovery is at a crossroad, easy policy can and will likely remain the game for some time to come. It will be the continued foreign inflows into capital markets that will therefore most likely dictate price action from here.

Global

While matters abroad remain critically important, focus on our side has shifted predominantly to local matters as the World Cup starts drawing to a close, SOE and union wage settlements have set nasty precedents, while the ‘tameness’ of social unrest will be something in the distant past the second the last Dutch camper van has crossed Beit Bridge…

Globally focus at present is centered around the technical outlook for markets and ongoing woes in the US housing market, as well as European banking and sovereign fragilities. Meanwhile India has hiked interest rates against expectations, and just to prove how uneven the global recovery really is, the Baltic Dry Freight index dropped 55% since early June to match worst levels witnessed in the midst of the 2009 recession, while Feeder Cattle and Lean Hog prices (key proxies for a shift up the wealth curve and reliable leading indicators) continue to trade close to multi-year highs.

Perhaps we can learn more though from the following excerpt from the SARB comments from yesterday, discussing the global economic outlook in particular:

The Secular Outlook of May 2010 issued by PIMCO’s Mohamed El-Erian, stated that “the drama playing out in Europe (includes) … the generalised and simultaneous nature of the debt explosion in industrial countries, the application and content of regulatory initiatives across the globe, the headwinds to job creation in some industrial countries, the extent of political polarisation and … the further shift of growth and wealth dynamics to emerging economies… “

It also became clear that in a number of countries and regions growth was dependent on the continued stimulus provided by the fiscal and monetary authorities. Initially fiscal expansion was required to fill the gap left by the collapse in private sector demand. However, the private sector, particularly in the advanced economies, was not ready to step back in to support domestic demand, largely because of impaired balance sheets.

Households remain cautious, and the initial driver of the recovery - inventory adjustments - cannot continue indefinitely without a recovery in domestic demand. The withdrawal of the fiscal stimulus in the US is therefore coming at an inopportune time.

In some countries, eg in Europe, the approach has moved beyond mere fiscal stimulus withdrawal, as in the US, to one of fiscal austerity or consolidation. These measures, while necessary from a sustainability point of view, are coming at a time that is in effect premature, and could well undermine the pace of recovery further. For example, it has been estimated that an attempt by the Greek government to reduce its budget deficit over the next three years by the 10 percentage points of GDP needed to bring that deficit into line with the Maastricht criteria could cause GDP to decline over the next few years by between a cumulative 15 and 20 percent.

The process of fiscal consolidation will place most of the burden of adjustment on monetary policies. In effect, we are likely to have low interest rates globally for much longer than previously thought. These low interest rates will counteract the negative growth impact of the fiscal consolidation.

Furthermore, central banks will, in all likelihood, need to continue to use their balance sheets to help support the financial markets.

** The Dark Cross : For the technically inclined the ‘dark cross’ implies the 50-day moving average breaking below the 200-day moving average, signaling a potentially bearish pattern. Out of interest, the previous time we saw the ‘dark cross’ was 20 December 2007 with the S&P 500 dropping from 1,490 to the beastly 666 in March last year, after which the ‘dark cross’ flipped into the bullish version of this cross at 900 - the ‘golden average’ - that lead to the rally back to 1,217.  Bear in mind that often on such a big break the market will attempt to claw back its losses with a move back to the support line, a rejection of this is termed a good bye kiss. The risk of this technical formation should not be underplayed in the current environment…