The State of the (European) Union...and Deleveraging in focus

The state of the (European) Union is quite terrible.

Europe, and the Euro, continues to unravel. Ireland did its thing on an Eu/IMF rescue package and the market gave it about a 15-minute welcome before hammering it, taking Potugal, Spain, Italy alongside. Many major commentators continue to spew venom at the ongoing tale of privatizing leverage and profits, while socializing losses and risk. Banks are not the most beloved institutions anywhere in the world, and the idea that banks and bondholders are being kept as pain-free as possible in this hastily-cobbled deal does have no chance of any popular support: there is no certainty at all that the Irish Budget will pass on Dec 7 or that the government will remain anything but lame duck. That has left Euro leaders notably Ms Merkel of Germany and Mr. Sarkozy of France scrambling to defend the currency union.

Aditya Rana quotes from Gary Shilling’s The Age of Deleveraging: Investment Strategies for a decade of slow growth and deflation and calls it a must read for serious students of markets and investing, starting off with saying that after four decades of leveraging up by the financial and household sectors, deleveraging is underway which is likely to take a decade or more. He says further crises lie ahead: another sovereign debt crisis in Europe with Ireland being the focus, a further 20% drop in US house prices due to the excess inventories and foreclosure delays which could push the number of underwater homeowners from 23% to 40% of mortgagors causing a sharp fall in consumer spending , a crisis in US commercial real estate which could exceed the housing crisis, a hard landing in China and a slow-motion train in Japan due to lower demand for its exports and an ageing population.

In terms of the current market, I continue to believe that long-dated US Treasuries offer exceptional value from a 6-month horizon with current yields at 4.30% - the ETF ZROZ, which invests in long-dated zeros, is currently trading at 73 (after having gone down to 69 last week) and has the potential to move towards 100 over the course of 2011. The US$ has, as expected, commenced its appreciation versus the Euro and is likely to continue to do so into the early part of 2011. Expectations of further QE programs are likely to cause sharp reversals in the US$, followed by periods of steady appreciation. Select EM equity markets are likely to be the main beneficiaries of QE programs, while grappling with high domestic inflation and real (and some nominal) currency appreciation.