Wednesday, 3 November 2010

US Elections – bad for Obama, positive for risk assets

The US mid-term elections ended largely as opinion polls had predicted. Republicans took the House of Representatives, Democrats kept the Senate. Given the influence of the anarchistic right-wing movement, the “Tea Party”, there is little reason to believe that the Republicans will co-operate with President Obama and the Democrats to solve the deep economic problems besetting the US. Instead, two years of further obstruction is likely.

Just like the Republican party (correctly) gambled on the economy not having recovered by 2010, the next Republican gamble appears to be that by simply doing nothing, the economy will have recovered somewhat by 2012. The election strategy will probably then be to claim having “saved” the US economy.

As a stark reminder of the seriousness of the economic situation, IMF and ILO yesterday released a study telling that since 2007, USA has suffered 25 percent of the job losses recorded globally.

For the financial markets, the consequences are likely to be the following:

No major economic initiatives will be forthcoming from President or Congress. 48 out of 50 US states are in deep economic trouble. No economic stimulus will be forthcoming from neither federal, state, nor local governments. Instead, budget cuts are likely to happen by default as spending programs expire and are not replaced.

This leaves Federal Reserve as the only institution holding the rope. Monetary easing is the only viable economic instrument available for a foreseeable future. Hence, the QE2 should be in the bag, and my guess is that it will come in two tranches of 500bn USD each.

As we have stated earlier, it will continue the ongoing inflation in risk assets, mainly stocks, commodities, gold, silver and tradable energy. The only question is how far it will run. No end in sight so far.

USD will remain under downward pressure until the US consumer demand begins to pick up in a substantial way.

Bond yields will remain under downward pressure from a combination of continued deflationary pressures and purchasing programmes from the US Fed/Treasury.

So-called inflationary expectations – which are in reality just a relative price between small-volume inflation bonds (TIPS) and big volume T-bonds - will point upwards but will have no real economic effect.

US corporations will continue to be hugely profitable in spite of unsatisfactory top lines. There will be a river of ink telling that it translates directly into higher stock prices. Wrong argument, but right conclusion. Instead we are looking for an increase in bank lending to private equity firms, looking for financing for leveraged take-overs. It has not started yet.

US policy makers stand pat and will have to play a waiting game. They are waiting for US consumers to finish the repair of their badly stretched balance sheets. As known from previous episodes of this kind throughout history, it takes years. The US consumer is 2-2.5 years into this cycle. There may be another 4 years to go.

Growth will be slower than trend growth in the time to come, and it is unlikely that the US Output Gap will have closed by 2012. Consumer Price Inflation remains unlikely.

Fortunately, things are looking better almost everywhere else.

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