Game Changer or Not?
That is the question on everyone’s mind.
Was this just another temporary measure in Europe that will fail sooner or later, and most likely sooner? Or is it something real. The start to a truly European Central Bank that can drive rates low as it chooses?
Is the economic data here stabilizing, albeit at an anemic level or was this too just an aberration and we are due to see the march of weak numbers resume?
To some extent, the real question is Europe having an “October 2008” moment where they are addressing some issues but the markets fail to respond for long, or are they having a “March 2009” moment, where suddenly everyone is looking for the “green shoots” or “brotes verdes”?
The Über Bull Case
This seems by far the most unlikely, but cannot be completely discounted. Europe stabilizes. The politicians start focusing on getting the economies in order. Not only do they implement some “infrastructure” growth products but they start forcing the underground economy into the taxpaying world. Here and there we get little hints of confidence and see diffusion indices creep closer to 50, and finally one of the periphery countries shows signs of small, but definitive growth off the bottom.
Some semblance of “business as usual” in Europe would creep into the U.S. data and Chinese data, taking some pressure off of earnings estimates. The slow job growth continues and accelerates as housing shows more signs of having hit bottom and global trade starts picking back up.
I find this case unlikely, but “green shoot” sightings can have a lot of impact. Expect European stocks and Banks to do the best under this scenario. They have paid the biggest price for the problems and will have the most direct benefits.
The Comme Ci Comme Ça Case
This remains the base case. Brief fits of happiness followed by outbursts of fear. Every time something positive happens, we get some negative headlines. The focus turns from Europe to our own Fiscal Cliff and broken political system. That we get caught by a rogue trader somewhere or that France was in worse shape than we fought. Some encouraging signs of life come out of Greece followed by more LIBOR arrests and lawsuits. Talk of QE spoiled by fighting in the Mid-East.
It seems that this is the mode we have been in and are most likely to remain in. We are near the high end of that trading range, and we should be waiting for the next bit of bad news. I think we will see balanced returns, where Europe and the U.S. take their turns leading the way higher or lower. At these levels, U.S. politics, deficits, and actual corporate earnings can be as much of a drag as news out of Europe. Fixed income should continue to perform, though with an outperformance from the risk on fixed income assets as opposed to the risk off ones.
Il Mondo si Trasforma in Merd@
I think this case is less likely than it was a week ago. The Central Bankers and Politicians are all too aware of it, and so scared, that they will continually step up and avert it, but it is still as likely as the most bullish case.
This is where we see a chain reaction of exits from the Euro, resulting in a global halt in trade and finance just like when the world froze after Lehman. An already slowing China cannot sustain any growth, and the fragile recovery in the U.S. is doomed to recession or worse by the events in Europe and our own inability to get the government to do anything.
The world spirals down, and nothing the central banks do is viewed as effective or is timely enough to avert another leg down. I think the risk of this is low and no great than the ultra bullish case, but isn’t off the table.
Europe will likely do worse because they don’t have a Fed, but China would also likely be a disaster. Puts are probably the best way to play this. Vol is relatively cheap and you are looking for 6 month puts, but with strikes of 1,100 on the S&P 500. If this case occurs, it will not happen in a straight line because the central bankers will try.
Good Luck to Knight
On a personal level, I hope it works out for many of the good people I know there (and even some of the ones I can’t stand). I think it would be good for the market if a company that takes relatively little long term risk is not put out of business by a computer going haywire. It may happen and we should all learn lessons from that, but I sincerely hope they find a way to be in business on Monday and slowly build the firm back up.