1) The recession IS over. But WHICH recession?
The recession is technically over. Most of us have been aware of this for quite some time. Earnings are growing, jobs are tepidly growing and the economy is growing again. Of course, this all sounds familiar to anyone who has studied de-leveraging cycles. An economy can grow while at the same time experiencing a balance sheet recession. This was clear in Japan where GDP actually expanded throughout the entirety of their lost decades:
Of course, global imbalances remain and the western world is still suffering from the damage caused by the credit bubble. While there has been much de-leveraging thus far the problems still largely remain. The continuing European sovereign debt crisis is exhibit A. The continuing troubles in the U.S. banking system are exhibit B. And the continually weak credit data is exhibit C. With U.S. housing in the early stages of a double dip it’s likely that the balance sheet recession in the USA will be tested again in 2011. If the housing double dip surprises to the downside we should not be surprised to be talking about the balance sheet recession for several more years as balance sheets are once again turned upside down and consumer credit problems persist. In addition, the Euro crisis appears far from resolved. And if I am correct about the banking sector it looks like Ben Bernanke is thinking ahead about bank bailout part deux. So, while the recession may have technically ended, the balance sheet recession is still very much alive.
2) What really caused the equity markets to rally since September?
In commentary yesterday David Rosenberg said the September-November rally in equities was not driven by better economic data:
“The bottom in the equity market rally came, not on a piece of data towards the end of August, but on the back of the comments from Ben Bernanke in Jackson Hole that another round of quantitative easing was coming our way. This is why the rally ended, not on any particular piece of economic data, but right after the FOMC meeting a few weeks ago — a classic case of buying the rumour and then selling the fact.”
This is factually false. The market technically bottomed on August 25th two days before the Jackson Hole speech. The market then kicked around the bottom until September 1st when China reported a strong PMI report and the ISM manufacturing report came in at 56.3 versus expectations of 53. The market rallied 3% on this news as it was clear that China was perhaps reversing several months of negative PMI reports and the USA was not going to suffer an immediate double dip. At the time sentiment was horrible and a double dip was widely expected. Over the ensuing few weeks we saw steadily improving jobless claims, improving global PMI reports, confirming ISM reports, improving PCE data, and the cherry on top was a very strong earnings season. Why is this important? Because the rally hasn’t been only due to expectations of QE. It has been primarily the result of improving economic conditions.
3) Is this the ultimate hedge?
In May 2010 I highlighted an interesting trade as a hedge against the Euro crisis:
“A fascinating trade is developing in treasuries and the gold market. We have this interesting correlation between treasuries and gold prices in recent months. As the Euro worries continue to develop both gold and treasuries have become safe havens. Of course, this has shocked the inflationistas of the world – many of whom are short treasuries and long gold, however, in this world of continuing low inflation treasuries continue to perform just fine. Aside from the firm fundamentals (U.S. government debt is not a concern and inflation remains low while the fundamentals for gold remain quite constructive) what’s become so interesting in this environment is that gold is acting more and more like a currency. In the long-run I feel as though this is entirely unjustified as gold will never serve as a reserve currency ever again. But we have what I believe is a unique window of opportunity here to buy both gold and treasuries as risk asset alternatives. It’s a beautiful hedge in a world that is grappling with the potential death of a fiat currency (the Euro) and continuing inflation or deflation. I don’t particularly like either treasuries or gold at this exact moment, but I will be a tempted buyer of both on any pull-backs. If the Euro crisis hits Defcon 1 (something I say is a relatively high probability event in the next 24 months) then gold and treasuries will soar.”
What makes this trade so interesting (still) is that they are the favored instruments of deflationistas and inflationistas. I continue to believe that we are in an environment where disinflation will continue and the risk of deflation will remain higher than hyperinflation. But that doesn’t mean gold can’t perform well in this environment. In fact, I have long said that gold is likely in the midst of an irrational bubble. The argument is simple – as fears of sovereign debt remain investors will continue to demand gold as a hedge against fiat currencies. What’s interesting here is that there is no solvency risk in the USA therefore we need not fear bond vigilantes in the USA. We truly are not Greece. Our monetary system is simply not the same. So, as long as the balance sheet recession continues in the western world the deflationary threat will remain and treasury yields will remain low, but the bid in gold will also remain as investors interpret the Euro crisis as a failure of fiat money.