The unexpected

The unexpected.
High summer. Although trading volumes are low markets seem happy enough. Oil prices have stabilized. The threat of a 'fiscal cliff ' seems to be receding and housing starts are up 25% y-o-y. Mr.Draghi's promise to do ' what it takes ' to save the € has removed some of the ' end of the world as we know it 'nervousness that characterised much of Q2 trading.

We however are concerned about two issues that are currently off the radar but may well be soon on it..

The Mid-East. 
The Syrian civil war continues. Turkey, the Gulf States , the Lebanon and Iran are all being drawn further and further into it. The Kurds are also becoming involved.  Stinger missiles and T-62 tanks have found their way to the rebels in Aleppo. Rumours that Saudi Arabia's new intelligence chief Prince Bandar has been assassinated by Syrian agents continues to swirl through the Riyadh exchange. Israel seems to be ever more insistent that action must be taken against Tehran and its nuclear pretensions. Domestic reports say that the Defence Minister Barack believes the government should act in the runup to the US Presidential elections. Egypts new fundamentalist President has fired the two most pro-western military leaders. Russia wants to evacuate its citizens from Syria but doesn't have the physical means to do so. Unrest has flared up in Saudis eastern province. Libya remains unstable. Taking all this together is there a chance of an oil price shock ? Something is stirring across the whole region.

Italy. 
It's not ( in our view ) Spain or Portugal or Greece or Ireland that will spook markets. It's Italy that presents the major threat to the Eurozone. Former Prime Minister Berlusconi is making plans to stage a comeback. He understands that the easiest option for Italian industry is to restore competiveness through a major devaluation. Hence the accelerating capital flight out of the country. Italian GDP at the end of Q2 was at the same level as it was at the same time in 2003. By year end it is likely to be on a par with the GDP level recorded at year end 2000. A lost 12 years! If the downturn in the economy continues ( as is probable ) then Italy could soon be back GDP levels last seen in  1997. With interest rates rising, GDP falling, and inflation remaining low there is ample scope for an 'Italian surprise '.

Enjoy August. September will soon be here and with it a raft of undiscounted conundrums for the market.

Delaying the inevitable ?

So the Greeks voted to stay in the €.  That at least is the spin that the French and German newspapers have put on yesterdays vote for New Democracy. The reality is that the new Greek government lacks a mandate to implement further austerity . It relies heavily on the vote of the over 50's. The under 50's voted for renegotiating the measures agreed with the ECB , IMF and EU. This morning the view in Athens amongst the leading pollsters is that new elections, with a very different outcome ,  will follow early next year .

The conclusion must be that the Euro will hold together for the rest of this year. In 2013 it now appears almost certain that Greece will drift out of the common currency . After all New Democracy is the governing party that got Greece into this mess and which has been irritatingly slow in applying the reforms that the ECB and European Commission have asked for . The long expected Grexit scenario still is in play . 

With growth slowing and unemployment rising pressures within Spain and Italy to move away from austerity are also growing . Rapid progress needs to be made on structuring a banking union and political / fiscal union if the crisis is to be resolved . If the next two EU summits fail to come up with real steps towards implementing these two measures then the risks of the Euro splintering into a hard Deutschemark bloc and a soft  , constantly devaluing , southern tier will grow. Where France positions itself between these two poles  is perhaps the biggest and most intriguing question of all. Will it lead the southern bloc and give up pretensions to being Germanys equal ? Or will it stick by Germanys side and put in place the steps needed to trim its deficit ?

All eyes on Greece.

Following the May 6th elections , the new government in Athens must now put in place further budget cuts . These have to be implemented by the end of June . Failure to do so will mean that The IMF will withold its next financing . The Greek authorities would then , literally , run out of money . A managed approach to austerity would then be replaced by chaos . 

The future of the €uro lies in Athens . Markets will be watching closely to see whether a coalition government can be formed in order to implement the changes. If not fresh elections will follow.  The chances of a Greek withdrawal from the common currency are real and rising . The new French President, Monsieur Hollande , may soon find out just how much the Paris banks are on the block to Greece.

End of austerity ?

An interesting week ahead in markets . Sterling / € at 1.23 today . The pound fast becoming a safe haven despite the UK's dire fundamentals . 1.25 possible by the end of the week .The €-zone rapidly heading for a political and financial confrontation , if not a full blown crisis. On one hand cash rich Germany . On the other profligate southern Europeans and their champion , the likely new French President, Francois Hollande . Will Germany listen to France and  accept the need for an easing of austerity ? If it doesn't what will happen to the Franco-German axis ? How will markets respond ? How will the UK ever generate growth if sterling continues to strengthen ? With unemployment at 24% what can the Spansih government do to stave off social unrest ? How will Italy's voters respond to the lengthening recession ? What happens if the Greeks vote against further budget reductions in their parliamentary elections on May 6th ?

Somethings leave you speechless.

Eurozone unemployment 10.7% up from 9.5% a year ago
Greek unemployment 19.9% up from 14.1% a year ago
Eurozone youth unemployment ( 16-24 years old ) 21.6%

Youth unemployment in Germany : 7.8%
Youth unemployment in Austria : 8.9%
Youth unemployment in the Netherlands : 9.0%
Youth unemploymemnt in Spain : 49.9%
Youth unemployment in Greece : 48.1%

The rise of geopolitics in portfolio construction.

Geopolitics. The markets new driving force .

A new worry is entering the investment landscape. Alongside the possibilities of a slowdown in China and a disorderly Greek default ( and the knock-on effect on Portugal, Spain and Italy ) concerns about the oil price are now beginning to impact the market. Just as 13.000 on the Dow seemed assured along came the real possibility that Israel and Iran might actually engage in a shooting war. This raises a number of questions . All of them pertaining to the longevity of the current recovery and the possibility of a sustained downturn.

Will Israel drag America into a war with Iran before the Presidential elections ?
Will Iran act first ?
Will events in the mid-East benefit Obama or Romney ?
What can the EU and other interested parties do to prevent conflict ?
What will Russia and China do ? A high oil price benefits one, harms the other .
What will happen to the price of crude if the Straits of Hormuz are closed ?
What will happen if the Saudi oil fields in the Eastern Province are subjected to bombardment ?
Can Bahrain contain unrest ?
What effect would an Israeli strike on Iran have on the evolution of the Arab Spring ?
If Gaza explodes can Egypt remain on the sidelines ?
Could Afghanistan erupt in an orgy of violence ?
Can the fledgling recovery survive the hike in gasoline prices ?
If India stops buying Iranian crude will the oil price hit $180 ?
What happens to the Spanish and Italian deficits with oil at these levels ?
Is Tehran happy to develop , but not build , a bomb ?
Are the Iranians rational ?
What will Pakistan do ?
Even if Nantaz, and Arak are destroyed , what else remains undiscovered?
Would the Fed embark on a new round of QE if the economy was to slow ?

The centre of uncertainty in markets is slowly drifting away from its obsessive concern over Greece and the Euro . An oil based slowdown in the world eceonomy is a parallel new wall of worry that markets must climb. Oil and gold still play a part in anyones portfolio.

What next ?

Iranian parliamentary elections on March 2nd . Will hardliners gain seats ? How will Israel respond ? Could Tehran cause trouble in Lebanon or the Straits ? Will I srael attack the enrichment facilities ? Oil price action and low equity volumes telling us this is the markets next fear . Greece and the upcoming LTRO forgotten - for the time being.

Kicking the can .

Supposedly an agreement in principle. More of a penultimate draft. No wonder Frau Merkel has so reticent in speaking out about it. All eyes now on the domestic German reaction and the way the polls swing . No doubting that this deal will be revisited after March 20th - probably sooner rather than later . €20,000 of bailout per capita and no final resolution in sight. Something in that number says this can't be right. To make it work three things need to fall into place . Greece has to return to growth. Without growth the agreement is meaningless. Then the Greeks have to accept the austerity the agreement stipulates . Finally, the next government has to stick by the agreement that has been hammereed out. In the absence of 1, 2 or 3 Greece will be back on the institutional radar screens by end Q2.

Can kicking

The Dow close to 13,000 . Markets enjoying a rolling top. Most institutional investors in neutral , unsure what to do next . The positive momentum in indices driven by hope. Hope that Greece will avoid default, hope that Europe will avoid contagion, hope that the US is in the midst of a cyclical rebound and past the worst .

Dominating every investment decision is the question - Will Greece default ? The answer lies not only in Athens but in Berlin . In recent weeks a split has developed within the German cabinet over the strategy that should be adopted towards their southern € - partner. The Finance Minister , Wolfgang Schauble, despite being an ardent pro-European, has expressed open doubts about the Greeks commitment to reform . In this he reflects the views of a large percentage of the German population plus many in the Dutch and Finnish governments.

By contrast Frau Merkel is keeping her cards close to her chest. She wants to see how the domestic political landscape develops in the aftermath of President Wulff's resignation . Above all she is interested in retaining power at the next election. This , in the absence of her rapidly collapsing Liberal partners , might mean forming a grand CDU-SPD coalition. To this end she will adopt a ' bide my time ' strategy and avoid any grandiose gestures that might lose votes . It does no harm to have Germany talk tough .

As of today it is likely that Germany will back the €130 billion bail-out package for Greece. Euro scepticism remains a large, but still minority, view . The final vote within the cabinet will be taken on short term political advantage - German short term political advantage. For the time being no one wants to be held responsible for vetoing the expected bailout. Expect markets to rally further.

The real turmoil lies ahead, after the French Presidential elections in May. Until then there are advantages for all concerned - Greeks, Germans, French, the EU Commission, Euroland banks - in preserving the status quo and kicking the can just a little further down the road . Even if , as expected, there is a debt swap , Greece , in the absence of growth, will be back at the centre of markets attention by the end of Q2. Default , but within the Eurozone , will be seen as an increasingly likely outcome .

10 Questions

2012 is shaping up to be a year of big , performance defining, geopolitical calls . For portfolio managers, weightings in the greenback, the € , oil , gold and commodities will in large measure be determined by the following.

• Will Greece default and trigger a Lehmann style event in the EU?
• Will Iran create mischief in the run-up to the US Presidential election ?
• Will the proxy war in Syria cause even more turmoil in the mid-East ?
• Could unrest spread to the Saudi Eastern Provinces ?
• What's the upside for oil - $120, $140, $160 ?
• Will Hollande beat Sarkozy in the French Presidential election ?
• Would a Socialist victory cause a rupture in Franco-German relations ?
• Is it possible Germany will start to question its €-zone membership ?
• How will the dispute between Argentina and the UK proceed ?
• Amid defence cuts in the US and NATO. Is military weakness provocative ?

We'll start working through our take on each of these tomorrow.

Interesting .

Interesting 2011 number just released from Eurostat. 45% of all Greeks and 39% of Italians have never used the internet . This compares with 15% of Germans and 11% of Brits .

From Goldmans . The Chinese economy is growing so quickly that it adds on output equivalent to the GDP of Greece every 130 days.

McDonalds says that it plans to open a new outlet in China every day this year.

So far 59% of corporations reporting their Q4 numbers have beaten expectations. The average uplift has been 11.5%. Without Apple and AIG this would fall to just 1%.

Interesting week.

Interesting week.

Courtesy of Mr.Bernanke we learn that 7 Fed governors are against rate rises before end 2014 / start 2015.That's a full 7 years after the start of the crisis. Yes , 7 years. More than a bit like Japans lost decade. Have to wonder what it is that the FOMC sees happening that requires rates to stay on hold for another 3 or 4 years ? Clearly they aren't forecasting a rebound in the €, muscular US jobs growth, or a decoupling of the US economy. Perhaps they're just trying to scare us and underneath it all they're more hawkish ?

Germany suggests that because of non-compliance a European Budget Commissioner should oversee Greek government spending . Athens huffily says ' thank you but no thanks '. It wants to retain its sovereignity regarding taxation and expenditure . This morning an announcement from Berlin that Frau Merkel will be actively campaigning for the re-election of France's President Sarkozy . She'll be seen " standing alongside him " . Quite how the Greek or French electorates will view this Germanization of their domestic political sphere remains to be seen. Reinforces my view that the real € crisis comes when the southern euroland states vote in 2013/2014. Of course the crisis could come earlier if Madame Merkels intervention fails to swing the election in favour of Monsieur Sarkozy . Mr.Hollande the Socialist candidate is already talking about renegotiating the treaty agreed at the last summit in December.

Interesting meetings in Switzerland earlier this week. Return with the feeling that politicians are still scrambling to catch up with the crisis. There is a danger in this. Social media is behind an attack on banks and bankers for having got us into this mess. Politicians are happy to leap on the bandwagon . '' It wasn't my fault " always an attractive position for the political class to take. But without the credit creation that banks provide where exactly would we be ? Where will we be as banks massively deleverage ? . Some hard socioeconomic questions will be coming our way soon . This week we learnt that Spanish unemployment is at 23% and rising ! Even more alarming , Spanish youth unemployment is at an astounding 50 %. Desperation levels.

The recent rally has started to run out of steam. 2011 earnings released over the last week or so are hinting that corporate margins are under pressure . Wall Streets brightest are waking up to the fact that growth is slowing, unemployment rising, and volatility is here to stay.On the positive side Armageddon has failed to take place and probably won't until 2014. November and Decembers market wide psychological depression has been replaced by a more measured tone. With the super cycle over governments will be forced into setting priorities within budgetary limits. This is a concept that is quite alien to any of the current batch of elected leaders. Reality will probably strike after the US election. Until then gold remains attractive on dips below $1700 and equities , despite an imminent golden cross, on a retracement towards 1280 on the S&P. Gilts remain the place to be .

Protectionism is the beast that could kill equities. There are signs that it's stirring in the runup to the US Presidential race. Time for a bout of China bashing ?.

National parochialism.

No surprises . The S&P downgrade of the credit ratings of France and other Eurozone countries has finally come through . On the positive side it wasn't as bad as it might have been . France was only cut by one notch, not the two that some observers had thought possible. S&P takes the view that the policy measures taken so far to address the crisis remain insufficient . Put more succinctly Europes politicians have been unable to rise to the challenges facing them. Parochialism rules.

Markets are unlikely to be unsettled by the S&P decision. More importantly, they will now be determining whether Moodys and Fitch will follow suit. We would expect Moodys to join their colleagues at S&P with a raft of downgrades possibly at the start of Q2. ( They have said they will review their rating of France at the end of Q1 ).A second rating downgrade may lead to institutional selling flows out of France and into the remaining triple A's. A textbook flight to quality . It would have been much easier for France and Italy if Germany had also been downgraded. Then the whole AAA benchmark would have been rendered moot. Once forced selling begins a second downgrade of France is possible as money flows from there into Germany. This is when the trouble starts.

Over the next month the key implications of this widely heralded move are likely to be political. Trying to get anyhting meaningful agreed in Europe ahead of the French Presidential elections has suddenly become much more difficult.Yet without political help for Spain and Italy the chances of the current techocratic government surviving decreases. By the same standards the chances for the election of populist governments increases. Hungary may be the tenplate of what lies in store for much of Europe.

1) The UK
Any remaining hope that Britain might sign up to the Europact agreed at the December summit has evaporated . The perception has grown amongst the British public that the Eurozone experiment has failed. A parliamentary majority for further harmonization is unlikely if not downright impossible. A Europe of 26 + 1 is now a de facto certainty. In the near term Sterling and gilts may continue to perform well. By mid year markets may begin to look at the falling value of the European collateral that the UK banks hold against their $2 trillion + of debt. Expect UK rates to be at a 3% level by year end.

2) France
The embarassment for the French government of losing their triple A rating while Germany and Britain retain theirs is tangible. The French government is now under strong pressure to give up more of its fiscal sovereignity and impose tighter austerity. This is something it has been loathe to do. President Sarkozy must now, quickly, decide whether to implement additional fiscal reforms or hang tough with the markets. Imposing spending cuts before an election is something he is against. Fighting the markets is something he cannot win. French banks are already set fo further downgrades, a process that can only sharpen if Greece were to default. Expect further Germanization of French policy.

The danger is that in the run-up to the May Presidential election , calls for France to leave the Euro or to renegotiate the European rescue accord are likely to grow. Things for France can only get worse. Germanys economic dominance of Europe is plain to the French electorate. France speaks of parity with its colleagues across the Rhine. The reality is clear.

3) Germany and Greece
Within Germany support for the Euro is showing the first tangible signs of waning. There are those within Chancellor Merkels own party who take the view that a Greek exit could be managed. We would expect a little more time to be bought for Greece at this weeks Troika negotiations. However, with an economy that has declined in size by 15% since 2008 the chances of repaying its debts become ever more distant and illusory. The real question is whether Greece can stay in the Euro while simultaneously defaulting . Removal of German political and funding support makes default more probable.This is something that we thought unlikely as recently as the start of the year.

4) Italy and Spain
It is only a matter of time before the austerity imposed on Greece, and soon to impact Italy, Spain and Portugal, causes popular resentment . Further election box driven changes to governments within the Eurozone will keep this crisis protracted.Germany seems to have decided that it wants its Eurozone partners to sign up to a radical fiscal pact . This discipline must be enshrined in the forthcoming treaty and only when the ink is dry will more radical solutions ( ie unlimited ECB bond buying ) be considered . Short term this may work . In the mid to longer term it is building up resentment and nationalism.

Conclusion
The European recession is now underway . Watch out for slowing economic output, downgrades by Moodys,further devaluation of the € ( a trading range of 1.15-1.20 to the $ seems reasonable ) and further pressure on the markets. At some stage, following a Moodys downgrade of France , Germany may decide to pull the plug on Greece and try to weather the resulting storm . Portugal would be next in line for a downgrade. Then ?. Sad, because none of this need ever have happened . And Americans think their politicians are bad .

Barring a political accident the probability is that by early next year the ECB will be forced into firing up the printing presses. As early as next week they may provide a further $700 billion of LTRO liquidity to the banking sector . If I'm right H1 2012 will be disinflationary and the latter part of H2 reflationary. That's when gold powers back through to the $2000 level and the S&P touches 1350 .In the meantime this drama will play and play and play . I'm still of the opinion that the crisis will come not in 2012 but in 2013 when austerity measures really take hold in Spain and Italy and when the new French administration understands the nature of the cuts it will have to employ. After the technocrats the populists.