Thursday, July 9, 2015

A Tragedy that Need Not Happen

Either of the literary variety - or literally speaking, tragedies arrive in different ways and forms. They can hit, seemingly out of no where - or from an expected and familiar place. It is the later, that can bring with it the disquieting voyeurism of watching the drama slowly unfold - then culminate with anticipated and tragic consequence. I.e. - "It was a tragedy waiting to happen."

When it comes to the fledgling European Union today, we have all watched the current events take shape, with the protracted inevitabilities of a summer stock theatre, that shows a Greek tragedy on Friday nights and Shakespeare's take of the form on Saturday. In classical Greek structure, the protagonist's fate is sealed by the larger more divine forces at play - that controls, leads and ultimately destroys the will and life of such a character in the face of immeasurable power. Nothing sells quite like helpless destiny at the hands of the gods. In contrast, Shakespeare's emphasis was laid at the feet of the individual, who's own actions and flaws eventually brings about his untimely ruin. Never discriminating a taste for ones suffering - self inflicted misery has also done quite well at the box office over the past four hundred or so years.  


In the EU's current schadenfreudian tale, they're collectively maligned by not only an inherently flawed political structure that has seen Germany act as a less than benevolent god, but also with a large supporting cast of individuals on all sides of the aisles with questionable ambitions and intentions. Nevertheless, a tragic denouement would be inflicted broadly and harshly, with the helpless victims - or heroes, invariably those who have already suffered the most - the people.   


So is Europe's fate already sealed and are we just watching its fifth act destiny unfold?


Although it's quite cozy to don your bear attire today and declare, "All is lost!", we maintain pragmatic expectations that a Greek deal will ultimately be reached with its creditors that keeps Greece within the monetary union and avoids a broader tragedy with certain humanitarian consequences to the Greek people and largely uncertain capital consequences to the EU and abroad. Ironically, the EU's flawed structures might end up saving it this time around from cutting off its nose to spite its face. Unfortunately, we're not so sure which would end up being the larger motivation - the people or the profits. Cynically, it's easy to believe the later - realistically, we suspect it's more than a bit of both. 


From an outlook perspective, the recent developments out of Europe as well as in China, has had a less than reflationary effect across markets, notably in hard commodities such as oil, copper and silver. While we had anticipated that the 10-year yield would retrace and consolidate before resuming its test of long-term resistance later this year ~ 2.65 percent, layers of uncertainty from both Europe and China have pushed back rate hike and inflation expectations in the US as further instabilities abroad would be broadly disinflationary. That said, we perceive both threats to be overblown with the later more panic driven and continue to view another important low for the euro in the markets rearview window as the current existential threat is overcome. 


In our last note on oil (see Here), the market was situated close to overhead resistance ~ $61/barrel, with the expectations that if the market broke out above would roll momentum in the SPX:Oil reflationary ratio lower, similar to what had occurred in 1999. What actually happened was oil was rejected at resistance and subsequently broke back below support ~ $58/barrel, as the deflationary/disinflationary threats out of Europe and China roiled world markets and pushed out rate hike expectations by the Fed.

Although we still believe that the magnitude of future policy tightening by the Fed will be exceedingly modest, we do maintain expectations that the Fed will move later this year and continue to view the prospects for oil as much brighter than the US equity markets. If the threats out of Europe and China abate over the next few weeks - which we believe they will, the SPX:Oil ratio should take another leg lower, as it did in both previous major exhaustion pivots in 1986 and 1999.
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Comparative Figures 2-7 were oriented based on the respective exhaustion pivots of the SPX:Oil ratio.
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