2011 Outlook from John Kicklighter
Written by JOHN KICKLIGHTER
DailyFX Currency Strategist
Those that Stick Their Neck Out the Furthest
Short: GBP, EUR; Long: USD
Fiscal responsibility is a good policy when it comes to the long-term health of a market and economy. However, when you are one of a few players that are looking to reign in the support when the rest of the globe is nurturing a still-weak recovery; it is asking for trouble. We have seen both the UK and Eurozone make considerable strides to cut deficits and reduce the threat of burdensome budget as well as sovereign credit rating pressure. And, over the long-run, these efforts will very likely help the economies and stabilize their markets. On the other hand, what happens in the event of a near-term slump in risk appetite and a stagnant period of growth? Those policy authorities that pursued austerity will pay for their efforts by amplifying the weakness of their economies. For the UK, the record budget cut and plans to cut 500,000 government jobs will reflect what impact it has starting in the 4Q and 1Q GDP numbers. Once that effect is noted, the sensitivity to risk trends will be leveraged. For the Eurozone, the application of austerity measures to already weak members will likely push these economy’s deeper into recession and further into financial turmoil – eventually spelling contagion for the entire region.
This will lead both the Euro and British pound to meaningful declines. And, where will the capital go? Naturally, investors will seek liquidity; but they will also look for support. They will find it in the US dollar. This development only speaks to the first stage reaction. The pain will be amplified in those austere currencies for sure. Yet when underlying investor fears level off; the survival of these economies able to maintain a conservative fiscal position will put long-term investors on the hunt for European and British assets. Both of these developments are likely to happen within 2011; with the first phase likely to come before mid-year while the second will take place sometime in the third quarter. When that second phase occurs, we can reverse that position to short Dollars and long Euros and Pounds.
A Collapse of Government-Sponsored Risk Appetite
Short: EUR, AUD, NZD, S&P 500; Long: Gold, USD, CHF
In contrast to 2009’s consistent advance in speculative and growth-dependent assets, this past year’s performance was far more volatile. What was the difference between these two periods? In late 2009 and early 2009, the governments of the world rushed in to guarantee risky assets, buy up toxic assets and pump liquidity into the markets. This was a rush of relief for a market that seemed on the verge of collapse. And in the subsequent reprieve, tremendous amounts of capital that was transferred into the most liquid and low risk assets had to make its way back into the market. That recapitalization lasted through most of 2009; but in 2010 the markets were once again topped off. Fundamentals would again come into play; but the side effects of government stimulus lingered and helped maintain to sustain risky positioning. And, in fact, additional stimulus was pumped into the system to prevent a European crisis from spreading, the US falling back into recession and Japan from a permanent state of deflation. This stimulus can certainly have positive effects on growth; but the benefits of additional support are increasingly marginal. Eventually the markets will have to make a natural correction to account for the anemic outlook for employment, growth, earnings, dividends and every other meaningful measure of activity and return. When this day of reckoning does come, the governments will find they are already over-extended and won’t have the necessary resources to fight a collapse in sentiment that is already acclimated to stimulus. That will only increase conviction in the subsequent unwind – especially in those assets that have reaped the benefit of stimulus.
Among the rank that will be hardest hit are the high-yielding currencies (Australian and New Zealand dollars), the euro which has seen cracks in the support of its 750 billion euro rescue fund and the S&P 500 which has been inflated by Fed stimulus. On the other end of this development is the market’s most liquid asset (the US dollar), the euro’s principle counterpart (the Swiss franc), and the asset that is considered an alternative store of wealth (gold). For a time frame, this will most likely happen in the first half of the year; but it is difficult to say how much stimulus will be pumped in to temporarily hold up the house of cards.