ECB and FOMC focus: Reform or not? C'mon!

Wow, it has been a long time since we had so much on the agenda in one week. Here are the highlights and some quick macro and investment allocation reflections: 

• ECB – June 6 – Will European Central Bank President Mario Draghi 'force reforms' by standing by or does he feel Spain is out of control and therefore sees a need to cut interest rates? Draghi also needs to weigh up whether to show his hand ahead of the Greek election and French Senate on June 17  (Odds 70/30 standing by as ECB otherwise loses yet more credibility) – More key dates
   
• FOMC – Bernanke June 7 – Will Federal Reserve Chairman Ben Bernanke drop hints about an extension of Operation Twist or Quantitative Easing III – or will he toe the line used recently: Unemployment is cyclical, so the “underperformance” we see is due to the equivalent over performance earlier in the year. His tail-risk is increasing as Morgan Stanley credit trades at junk level and JPM still remains under pressure from its credit derivatives. (We are 50/50 on Bernanke, but think his context will be extremely key for whether we are in for more easing in July or September.)
   
• US and Global data getting close to its low? We have constantly tried to remind people that economic data expectations are mean-reverting. In Q3-2011 every man and his dog called for a double-dip recession, while we, were contrarian purely out of respect for mean-reversion change to outperformance. Now fast forward to 2012. In Q1 the world of ivory tower economists were calling on the US to do much better. Once again we were contrarian, though purely based on mean-reversion (our Q1 Outlook was actually called: Perfect Storm).  Yes, now we are nearing that, but not yet at the low end. (CESI – Citi groups surprise index is at - 53 – a perfect repeat of last year will see it drop to -100 by August – and then we will see a repeat of 2010 and 2011 in 2012…..)
   
• Portfolio returns: We run several benchmark models measuring relative performance. Here are a few notes: The Endowment model is now neutral on the year after the best start in decades. Re. Global Recession, our model is designed to play what is says. It is now the best performing index with +229 bps, followed by Upside surprise and Consensus which both are down 49 bps. Meanwhile, our long credit play – high yield opportunity fund is up +10 percent. This shows us that investing in the micro-economy where it’s needed the most works: Capital lending is still performing despite an extremely weak May. We do not see this changing although further sell-off could mean the 10 percent becomes 5-6 percent - still more than a decent return though.
   
• Allocations: We bought GDX last week based on the re-run of 2008 where GDX (miners) were up 100 percent before the low in the market was in. This was covered in my earlier piece:  QE Alert! Central bankers realizing they are behind the curve. Now, it is always easy to remember one's good trades. However, I mention this trade only because it is a clear indication of monetary easing ahead and a repeat of 2008; the GDX is now up 20 percent since the post, indicating to me that we need to look for an exit from the short inside the next 4-5 months as the timeline in 2008 (as seen in the link above was October 2008 low in GDX followed by the magic 666-00 low in March of 2009. Of course history never exactly repeats itself, but the overall theme plays well with my firm belief that we are nearing the “mandate for change” which I have talked so much about. I do realise that 95 percent of you probably believe that the world will continue to do Pretend-and-Extend Light but I have to believe in my analysis which says Germany is at the end of the road, and any step from here on will be burdened by huge financial risk and liabilities.
   
• Fixed income levels are unreal: Looking at the magic trade for one, two and three years down the track has to be shortening fixed income. Yes, the cemetery is full of people who tried it, but listen, the world is not that bad – it makes no sense to invest in 10-year government liabilities at 1 percent when you know everything governments virtually do is wrong. Investing the same amount instead in rational companies and people is a better way to go, but be my guest. (My timing model is getting ready to ditcsh IEF – (7-10 Year US bonds) – again based on my principle of mean-reversion.)

Conclusion
Every day that goes by without any move towards reforms and freeing up the micro-economy is taxing on future action. The price is increasing on a daily basis and Germany is right in claiming that without fiscal prudence you have nothing. It’s like a country without a rule of law, or even worse, property rights. It may not be politically acceptable, but Germany is right, and involuntarily so. This week and the next will tells us whether the ECB goes for reform or not. If Draghi does anything then talk of reforms need to stop – and Europe is worse off. If Draghi waits (until June 17 and the next EU Summit), then at least he tried.

Likewise with Bernanke – if he stays close to the script then he should wait. I can’t stop laughing at how Greenspan (his predecessor) on the day the market tanked was out saying stocks should go higher

May 2 (Take the plunge? Set the micro-economy free) – my advice to Ben? Take it easy Ben – wait for Greenspan to go negative and you are fine. The US economy is not in free fall. If anything the recent non-decision political environment in the US has been positive. The less macro the better.

June 6/7 are key dates – inside the next 48 hours we will know if reforms are still the solution or not. Stay posted!

Safe travels,

Steen Jakobsen