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    MARKET EDGES

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“I must begin by saying something about the old Germany. That Germany, too, suffered from superficial judgment, because appearances and reality were not always kept apart in people's minds.

-Gustav Stresemann

Last night in thinking about a theme for the Early Look I read an article by John Williams and the concerns he has about the current economic policies.  The article was an extreme view, as he believes that the U.S. economic and systemic solvency crisis of the last two years are just precursors to bigger problems: this crisis and others in the past are being brewed by the federal government and the FED’s malfeasance.  

One of our key themes for 3Q10 is “American Austerity”, a key tenant of which is that the “Fiat Fools” in Washington are dedicated to preventing deflation and the subsequent debauching of the U.S. dollar. The article by John Williams takes this to an extreme and uses the period in German history called the Weimar Republic as a case in point. 

According to Wikipedia, the Weimar Republic is the name given by historians to the parliamentary republic established in 1919 in Germany to replace the imperial form of government.  It was named after Weimar, the city where the constitutional assembly took place.  In its 14 years, the Weimar Republic was faced with numerous problems, including hyperinflation, political extremists on the left and the right and their paramilitaries, and hostility from the victors of World War I.

Post-World War I, Germany was a country that was financially and economically depleted as a penalty for losing the war.  By late 1922, the German government could no longer afford to make reparations payments, in keeping up with the Treaty of Versailles.  As such, paper money was printed, the market collapsed and foreign investors withdrew their capital.

The Weimar circumstances and its heavy reliance on foreign investment reminded me of our relationship with the Chinese and how dependant we are on them and their confidence in the US Dollar.  Unfortunately, this may not always be the case.   See our post from 7/16 “Watch What They Do, Not What They Say . . . The Chinese Are Selling Treasuries.”  There is a reason why Timmy has taken a kind and gentle approach with the Chinese and their Yuan policy.

For the time being, the “Fiat Fools” in Washington can rest knowing the government contrived reporting of inflation is benign.  Last week the BLS reported that consumer inflation appears to be under control - but for how long? 

It’s only a matter of time before inflationary pressures will begin to surface from the debauching of the US Dollar.  A weakening U.S. dollar will continue to put upside pressure on dollar-denominated commodity prices, which in turn push inflation higher in the system.  The key here is that it’s not inflation generated by strong economic demand, but by policies driven by “Fiat Fools.” 

The implications of the recent rebound in the Euro (and the subsequent decline in the Dollar) suggest that market concerns already may be shifting from European solvency issues to those of the United States, but not so fast. 

Since the Euro’s low on 6/7 it has rallied 8.5%, but it does not look like the Euro zone is out of the woods yet.  As Daryl Jones, Head of Hedgeye Macro Strategy, noted, “three month Euro LIBOR is up over 30% in the last three months.  The credit worthiness of European banks is being question by their very own peer group.  That’s not good for liquidity in the Euro zone.”

As MACRO trends continue to point us in the direction of another recession, the implications of worse-than-expected ballooning federal deficits will bring the issues of U.S. solvency and U.S. dollar soundness front and center.  The Hedgeye Macro team will address this topic on a conference call in the coming weeks.

For now, on center stage is the tug of war between the strength of corporate earnings and the weakness in the economic numbers, and the battle is leaning toward MACRO trends.  So far this earnings season, 32% of the companies that have reported have missed on revenue expectations (60% of the companies that reported yesterday missed on the revenue line).  This compares to 32% for all of 1Q10. 

Relative to earnings expectations, only 20% of the companies that have reported have missed.  Top-line trends, however, are more indicative of real consumer demand and the sustainability of earnings trends as companies cannot cut costs forever.  Relative to current guidance, the storytelling continues. 

If we assume that the best of the best typically report first, the balance of the earnings season will not be supportive of equity prices.

I don’t claim to be a German historian or that the USA is going to feel anything like the pain Germany felt between 1.  At Hedgeye Risk management we like to keep history is perspective and our eyes open every morning to the realities of the day ahead.   

Function in disaster; finish in style

Howard Penney

Weimar Republic - mark