Asset Allocation for volatile times

While recent economic data point to better global growth, the European sovereign crisis is likely to flare up again in 2012. The third year of austerity is likely do depress European economies further. Help from Germany in the form of sound macroeconomic policies - such as higher inflation targeting, increased private spending - are unlikely due to deep seated but misplaced inflation fears. The Euro currency's survival is a matter of when not if.

Against this backdrop I remain overweight safe haven assets, primarily USD denominated, that have performed well in 2011 - such as long term U.S. Treasuries which returned 27% in 2011. Naturally, a portfolio should be diversified, containing both higher and lower beta asset classes. Hence, my personal allocation contains US and EM equities. I avoid, however, European debt and equities.

Exposure to the asset allocation below can easily and inexpensively gained through exchange traded funds  (ETF). TLO for long-term US government debt; N6M (Singapore traded) for Asian fixed income; VYM (US traded) or I17 (Singapore traded) for S&P 500 exposure, IAU (US) or O87 (Singapore).

Merkel fans the flames

Merkel is set to bring Europe to its knees with her misguided view that structural reforms and austerity will "normalize" Europe's debt costs. Bloomberg:

Merkel rejected French calls to deploy the ECB as a crisis backstop. “If politicians believe the ECB can solve the problem of the euro’s weakness, then they’re trying to convince themselves of something that won’t happen,” Merkel said.

Even if reforms and austerity would work eventually, denying the markets an urgent and critical backstop much longer will lead to a financial meltdown, undoing decades of European integration. The financial systems' vital signs - interbank lending, interest rates, money supply to name a few are in critical territory. Her comments along with those of other German government officials have served to increase spreads and risk aversion.  


By all means, let the summitry continue, but not with the patient on life support. Here is to hoping that Merkel will reverse her decision quickly as she has done in the past when reality intruded on her poor judgement and not veto an expanded ECB mandate. 

Stage set for European bank runs?

In their zest to bully convince Greece to accept more austerity for more aid, Germany and France may have set the stage for bank runs. Joachim Fells of Morgan Stanley:

This past week, by raising the possibility that a country might (be forced to) leave the euro, core European governments may have set in motion a sequence of events which could potentially lead to runs on sovereigns and banks in peripheral countries that make everything we have seen so far in this crisis look benign. 

I continue to remain short the Euro vs the US Dollar, long the long-end of the U.S. Treasury curve, short WTI crude oil and short financial institutions.

Markets too exuberant about German vote

Today's vote in Germany's parliament on strengthening the European stability fund will almost certainly succeed. Yet, the Bundestag is voting on too little too late. If this past weekend's IMF/Worldbank meetings are any guide where little was achieved but Gaithner managed to talk up the markets, a supportive Bundestag vote will lead to a short lived rally.

None of the underlying issues are being resolved or discussed. European and U.S. policies likely continue to be medium-term supportive for US government bonds (particularly on the long end), and supportive for ETFs / mutual funds short the Euro, oil, and emerging market currencies. Gold is likely to resume its upward trajectory.

The Euro Breakup now my base case

The past few months have left me disillusioned. European politicians fail to grasp the severity of the crisis at their hands, much less comprehend basic economics. German politicians have made it abundantly clear that they are against Eurobonds, the last best hope of saving the Euro. What’s under way right now is a full-scale market run on the much larger economies of Spain and Italy. 


My base case is a Eurozone breakup. I continue rotating out of long stock positions. Trade ideas I have implemented in the last few weeks (ETF ticker in parenthesis):


Key conviction ideas:

• Long the long end of the Treasury curve (TLO; LBND for a more aggressive posture)
• Short financial stocks (SEF)
• Short Euro currency (EUO for leveraged short)
  
  

Conviction ideas:

• Short oil (SCO) on slowing global economic growth
• Long gold (IAU)
• Minimal overweight in emerging market bonds (EMB)