The Markets

We’ve spent quite a bit of time in this column over the last several months on the three possible economic scenarios facing us and their implications for asset allocation and geographical diversification of your portfolio.
Scenario One is the “U.S. as locomotive” that pulls down the rest of the globe if the U.S. is in a recession. That’s bearish for equities, energy, gold, and commodities but bullish for bonds and global diversification provides no safe haven.
Scenario Two is “decoupling” in which Asia and Latin American continue to boom and Europe grows robustly even as the U.S. is in recession. That’s bullish for equities internationally as well as for energy, gold, and commodities but bearish for bonds.
Scenario Three is stagflation – simultaneous recession and inflation. That’s a very bearish scenario as both stock and bond prices move down, making asset allocation hedging difficult. While gold may be a decent bet, there’s not much else to bank on.
I raise these issues because the latest round of economic news has pushed us closer to the stagflation scenario – very bearish news indeed. That news has included: A hot core PPI in the U.S. and an inflation warning from the Fed, a continued drumbeat of warnings from the European Central Bank, and a $135 a barrel oil coupled with China’s earthquake and its already double-digit inflation.
We now face the prospect of rate hikes in the coming months by central banks all over the world – and the Fed Funds futures are now putting the odds of a rate hike in October at better than 50-50.
Europe is facing perhaps the most difficult task. On the one hand, Germany is cranking on all cylinders, primarily because of its export of capital equipment to Asia – that argues for a rate hike by the ECB. However, Italy and Spain are basket cases – and that argues for a rate cut. Look for fissures to develop in Euroland over the next year as deficit spending by the countries in trouble put the internal currency parities out of whack.
As for China, the recent earthquake may wind up shaking the political establishment as much as China’s terrain and structures. While the government has thus far gotten kudos for its relief efforts, protests are beginning to erupt in the affected areas as corrupt or inept officials fail to provide adequate water, food, and shelter – even as some skim some of the money for their own pockets.
Maybe the best place to be right now is Brazil. With food and fuel two of its primary exports and with its own domestic markets developing apace, this country may finally overcome the bon mot: “Brazil has a great future – and it always will.”
My bottom line for the week is, as I hinted at last week, selling now in the end of May and going away may be the best strategy for those of you who fit more into the trader camp than the investing camp. For the more adventurous, you may also want to think about a short on the oil sector. This looks as much like a parabolic rise as any I’ve seen. It will be difficult for the global economy to withstand the stagflation shock and IF the global economy does succumb to recession, oil will head back down towards $100 a barrel a less – at least until secular forces fuel another upward move.