PREAMBLE

On Tuesday 10 July Rob, an Ecinya reader, made the following comment in relation to our Strategy Musings of Friday 6 July. He said…...

George, a good article summarising where everything currently stands. The overriding theme throughout the article is that we are in a holding pattern in an event driven market. Could you perhaps elaborate how you are forming the view of being more bullish given the neutral nature of the paper & a decision to not yet revise your downside targets. Looking forward to your response.

Rob, the answer in essential terms is that things change because they have to. The world moves from success to excess, from boom to bust, from recession to recovery, from disequilibrium to growth. Interest rates go down, confidence goes up, earnings recover and valuations improve. Spring follows winter, spring precedes summer, autumn comes, winter returns. The road to recovery is not linear, it is often opaque, it is bumpy in economic and stock-market terms. Timing is always difficult. Ecinya currently believes that we have entered the beginning of the recovery phase and a solid down-leg from here in All Ordinaries, Shanghai, and SP500 terms would provide a technical and fundamentally sound base from which the next sustainable bull-market can begin.

Chaos isn’t dangerous until it begins to look orderly is one of Max Gunther’s Zurich axioms and descriptive of the unfolding of the post US and European banking crisis. There was no GFC, in our opinion, as Asia escaped and it was just a convenient label for Mr Swan, Ms Gillard and Mr Rudd to behave irresponsibly and give hand-outs for Australians to buy flat screens and other electrical devices. Reflation always needs to create sustainable economic outcomes and short-term fiscal stimulus is generally unproductive. Now that the real GFC has arrived Australia has no biscuits left in the tin and fiscal initiatives are being funded by debt.

In part our 6 July Strategy offering said………..

We are becoming a little more bullish, but it is a time to be extremely patient, to allow the global cleansing process to continue to evolve. The conspicuous failures at JP Morgan and Barclays Bank are welcome relief as the scallywags (or criminals) have been exposed. More are sure to follow. This might mean that our 13 January downside target for our global proxy – the SP500- of 1120 (a fall of 18%) comes into view. We hope not, but we are not yet prepared to upgrade that downside target.

Kevin Armstrong, our visiting contributor in ‘Insights’ is firmly of the view that even more substantial downside targets are in prospect. For our part we still believe in the power of fiat currency to save us from cataclysmic market failure. Targeted austerity (aka fiscal discipline) would obviously assist.

We recommend a visit to our last 3 Insight essays so that a competing and, in some respects, a complementary perspective can be obtained. These essays are; ‘the four UNS’, ‘Looking back in order to look forward’, and ‘All roads lead to somewhere’.

On 13 April 2012 our simple thesis was: Europe can’t YET go forward; China can’t go back; America needs to work out where it wants to go; and, Australia needs a Federal election as soon as possible. More than half of our local economy is verging on recession and the stupid carbon and mining taxes that have recently been imposed, have reduced a wavering level of confidence to something near melancholy; savings are up, domestic investment is down, and spending is on the skids. The real engine of pervasive growth, the small business sector, is in disarray. Net collections from the new taxes will probably approximate zero, after compensation and other fiscal expenditures or lack of fiscal discipline.

Going further, time is needed for it to become abundantly clear that the current Federal Rudd-Gillard-Greens government are economic vandals and fraudsters. That is not to say that the alternative has yet convinced themselves, or us, or the broader electorate, that they are a totally viable alternative. An election campaign should help as the detail of the policy debate is revealed. The Labor party, in our view, is likely to replace Ms Gillard in the very near term. An election held this year would, in our view, be a major market positive. ‘In the land of the one-legged drongos, the two legged drongo is king’.

It is clear that Mr Swan is a most inept Treasurer with a running mate as Prime Minister unfortunately out of her depth and clearly lacking the experience to lead the nation. The Labor government overall has become somewhat delusional and the Hawke-Keating-Walsh-Howard-Costello fiscal balance sheet and economic legacy has been comprehensively destroyed.

On a much brighter note it is pleasing to see that global reflation is in the wind as interest rates are shifting to the downside.

 

TARGETS WE SET ON 13 JANUARY 2012

The SP500 will have a range of 1120 to 1350 finishing the year close to, or above, 1350. The first half will be volatile to the downside and the second half volatile to the upside.

The XAO will have a range of 4000 to 4950, closing the year close to the high end of that range. The first half will be volatile to the downside and the second half volatile to the upside.

Our major Black Swan event, which is not priced into these forecasts, is war against Iran from the US and Israel, and possibly and preferably (should it happen) joined by other Arab countries.

 

TARGET REVISIONS

We now revise our year-end upside target for the S&P 500 to 1380 (from 1350) and upgrade our downside target to 1180 (from 1120). The year-end upgrade is a mere 2.2%, the upgrade to the downside target is 5.1%. However, the more important point is that we are looking for a sell-off in a series of phases that takes the SP500 down about 14% from current levels or about 17% from the 2 April closing peak of 1419. That will, or should, form the basis of the next bull-market, subject to our caveats set later in this paper.

From our Ecinya market quant model the implications for the All Ordinaries (XAO) index is a year-end close around 4310 and a low around 3700. The XAO forecast range thus narrows from 25% to 16%.

All of this means that our January Overview has proven to be near enough to correct, but mostly for the wrong reasons. Let’s find someone to blame….. Ben Bernanke is the obvious choice but the US Congress and Europe have played supporting roles. European bankers could not escape the contagion and poor lending practices of Wall Street. Too many European governments (Germany the big exception) moved too far away from the axiom that "What makes good common sense generally makes good economic sense." The real economy of production of goods and services has been overtaken by the symbol economy of money and credit. The result is a paucity of production and ever-rising levels of unemployment and the result is pessimism and social unrest. Europe has a lot of work to do and structural reform of the Euro must be considered. Our guess is that either Germany or Greece should leave, preferably the former to give the other lesser nations the ability to devalue.

 

WHY DO WE FOCUS SO MUCH ON OUR GLOBAL PROXY, THE S&P 500?

Australia bats at about number 17 in the G20 and America and China are at 1 and 2 respectively. However, in per capita terms China falls over, except that the gap is narrowing relatively quickly. Two of our enduring quotations have come from Ian Macfarlane and our favourite Australian post-war politician, Peter Walsh…………

Ian Macfarlane, former Governor of the Reserve Bank, in June 2005 said:

"The principal contribution that monetary policy can make to economic well-being is to maintain low and stable inflation. I think it is true to say that if you wished to forecast the path of the Australian economy, and you were able to have fore-knowledge of only one economic variable, the one you would choose is the path of the world economy. That is not to say that we have no influence over our own destiny – we can make the situation better or worse than it would otherwise be – but we cannot escape the influence of the world business cycle and the other factors that feed off it."

Peter Walsh, Finance Minister under Robert Hawke said, in 2003, criticising his own side of politics:

"All countries which accumulate debt and habitually run big current account deficits are vulnerable.And for many centuries societies have been susceptible to irrational booms,South Sea Bubbles,tulip bulb booms,and dot com busts. But no central bank can offset the cascading effects of bad government policy."

Australia has a narrow and deep export base and a broad and deep import base and it is important that domestic budget surpluses be preserved and that budget deficits be shallow. The Rudd-Gillard-Greens coalition government has departed from this wise counsel and HAS made things ‘worse for itself’. Bad governments historically misallocate scarce resources and this makes it difficult for independent central bankers to move towards lower interest rates. In America the Federal Reserve only pretends to be independent and with the $US being the world’s reserve currency and the US the world’s largest economy, the spillover of bad monetary and fiscal policy to the rest of the world creates difficulties.

 

Ben Bernanke

When Ecinya formulated its 2012 market thesis we never envisaged that Congress would continue to provide stimulus concurrently with Uncle Ben’s QEs and close to zero interest rate settings. The QEs have been so pervasive that corporate America and Wall Street have hardly felt the debacle of the sub-prime crash and the costly wars against Iraq and Afghanistan which have brought into the economic lexicon….. ‘the fiscal cliff’. Fiat money may well be the parachute that saves America from going over the fiscal cliff to a softish landing.

Messrs Greenspan and Bernanke have presided over a new era of economics which have involved commercial excess (Dot-com and sub-prime bubbles) and a dovish approach to TARP followed by money printing cloaked in a tapestry of obfuscation and innuendo. Will we survive it? Will there be a global recession in 2013? Ecinya’s view is YES we will survive and NO there will not be a global recession in 2013.

According to the 31 December, 2011 issue of The Economist, champions of ‘Modern Monetary Theory’ are calling themselves neo-chartalists. They believe "That because paper currency is a creature of the state, governments enjoy more financial freedom than they recognise. The fiscal authorities are free to spend whatever is required to revive their economies and restore employment. They can spend without first collecting taxes; they can borrow without fear of default. Budget makers need not cower before the bond market vigilantes. In fact they need not bother with bond markets at all."

As always conditions precedent prevail and caveats are always blowing in the wind. Our caveats were contained in our essay of 7 October 2011 when we posed the question ‘Is austerity or reflation the pathway to economic recovery?’ Our conclusions were that both were required but in a properly targeted and timed manner. If austerity is happening in global centres then we are only faintly aware of it as the reality and rhetoric diverge. In Australia the various debacles have continued with the latest education handout and the National Disability roll out. Refer below to today’s editorial commentary in The Australian.

In our 7 October essay we envisaged a return to normality. So far we have been completely wrong, especially in relation to timing; fundamental change does not occur quickly. We are now looking to the fourth quarter of 2012 to determine whether we are on track towards a sustainable recovery. Our hopes are high and our analysis is reasonable, in context of economic and market history. Note that the US Republican Party Convention finishes on 27 August and the US election campaigns then begin in earnest. Both parties need to move towards the centre and if they do not then the current mayhem may become somewhat extended. Time will tell.

Our then and current view of ‘normal’ included the following –

What does ‘normalise’ mean?

In our view it includes the following –

• A stronger US dollar.
• A cessation of Congressional hostilities leading to an outbreak of fiscal responsibility.
• The election of a thoughtful and economically literate US president (Mitt Romney seems to have the appropriate CV) or Obama changes his administration to swing to the right towards the centre.
• Tax reform in America… probably a national GST/ sales tax.
• Institutional reform leading to institutional accountability.
• A reduction of European welfare.
• Recapitalisation of European banks.
• Cessation or extreme modification of the European Union and a return to sovereign states allowing some states to use their own currency alongside the Euro. Additionally beneficial trade treaties can be negotiated… not ‘free’ trade agreements, there is no such thing as ‘free’.
• Relative peace in the Middle East aided by a European-Arab reconstruction fund.
• In China we need to see the continued emergence of the middle class and certain safety nets for workers which will increase Chinese production costs and re-balance their trade to some extent. Safety nets.. superannuation, minimum wages, less exploitation, workers comp insurance etc.
• The Chinese Communist Party should change its name to ‘The China Central People’s Party’ to indicate a deper engagement with the west and acknowledgement that it has become a free enterprise economy. China is not yet ready for democracy.

Our summary overview of that October paper was –

Economic forecasts are being wound back fairly dramatically as practitioners have realised that they have got their 2011 forecasts wrong as Bernanke’s stimulus bounties underwrote the 2010 recovery. Take away the drip feed and the patient dies. As an example world growth according to Westpac Economics latest projections is expected to average 3.5% over calendar 2011 and 2012 compared with 4.2% just 3 months ago. The circa 1% difference is about US$700 billion in real terms. Fears of double-dip recession are expressed daily from reputable sources. America is struggling on all levels – fiscal, monetary, militarily, national identity; Europe has a banking and sovereign debt crisis, Japan is recovering from a natural disaster and years of almost zero growth, the Middle East and North Africa are at various stages of civil war. Strife abounds, which in simplistic terms means we are in the early stage of the opportunity cycle. Though there won’t be much evidence of recovery in calendar 2011, if policy makers work hard and politicians start to behave like adults and each communicate well, then the world should experience a normal recovery in the last 3 quarters of 2012. "Is austerity or reflation the pathway to economic recovery?" Our answer is – both are required, but with the weight on the reflation leg.

Since the first cut of second quarter US 2012 GDP was announced last week at 1.5%, economists have been busily downgrading their Q3 and Q4 forecasts. Fortunately we can take comfort in the fact that most economists rarely get their forecasts right. Thus it would not surprise us if Q4 numbers for 2012 and Q1 numbers for 2013 began to be incrementally upgraded sometime after 30 October. Global forecasts are weakening and a downgrade by the IMF for 2012 and 2013 would also be bullish as they are invariably wrong. We are expecting that at about the market bottom…. a pervasive headline will be "IMF WARNS OF GLOBAL RECESSION".

 

Mario Draghi

Mario is President of the European Central Bank. We were not much impressed with his recent remark that he ‘would save the Euro no mattter what.’ This is the kind of silly statement that push central bankers into corners from which they cannot escape and from which bad policy can flow. It is hard to fathom what he is talking about. Does Germany leave thus saving the Euro for the other underwater nations? Does Greece leave thus saving itself by defaulting? The Euro was a bad concept and it has found to be unwieldy and cumbersome. Asking sovereign states to give up their identity is nonsense. Asking Germany to save everyone else won’t happen. Asking Greeks to pay tax when evasion is a national sport has difficulties. Riots in Spain and Greece are unproductive. A 5 year rolling plan based on fundamental realities would help, but that has not been forthcoming. Instead we have has soemthing like 22 summits and a communique from each about ‘constructive dialogue’. Europe is a wonderful place, a mystical and charming place, but having been bailed out after WW2, it is the land of the free lunch, with some obvious exceptions, but it will take time to get it near enough to right. Mr Draghi so far is not helping. We perhaps should also note that Italians are reluctant taxpayers.

 

THE AUSTRALIAN

 

Ecinya’s response to Mr Swan’s Euromoney award was contained in our essay of 23 September 2011: ‘Mr Swan’s award is a sad metaphor for the world’s economic and banking mayhem.’

Mr Wayne Swan has joined Paul Keating as the second Australian Treasurer to be named by banking magazine ‘Euromoney’ as the world’s finance minister of the year. This seems to be a sad metaphor for the bizarre science that economics has become led by the scallywags of Wall Street and the economic elites of Europe. Australia entered the global financial crisis with a record terms of trade, a domestic surplus and zero foreign debt. Under Mr Swan’s stewardship we have significant debt to be repaid, a domestic deficit, most state budgets pressured, and the prospect that our major economic saviours – China and Asia generally – need to rebalance their economies as Europe and America soften. The steady and pragmatic policies of Hawke-Keating-Walsh and Howard-Costello have been forsaken for failed ideologies of the past and populism and hyperbole of the present.

We found it difficult then, and even more difficult now, to understand how a well regarded magazine like Euromoney could make such an award. The magazine in our view added to instability and uncertainty by being uncaring, shallow and oblivious to the fact that Australia has regressed badly under Mr Swan as Treasurer. In our view at that time Australia became exposed to an Asian and global slow-down which exacerbated the negative trends already evident in the local economy. We bestowed upon Mr Swan the title ‘Australia’s second worst Treasurer’ but did not name the worst. We now upgrade Mr Swan to ‘Australia’s worst ever Treasurer’ and apologise to Mr Frank Crean (the previous worst) and his family. Mr Crean unfortunately fell under the spell of Australia’s second worst post-war Prime Minister, Gough Whitlam.

Just a throwaway note of not much relevance to anything, except Mr Swan’s economic idiocy…… according to the Celebrity Wealth.com web site…. Bruce Springstein is worth US$200 million.