Beyond the debt crises

A late-summer bounce beckons for stocks and other higher-risk assets if U.S. officials can follow Europe in at least delaying a deeper crisis over growing government debt.

Broadly, asset managers have so far reacted to the debt troubles on both sides of the Atlantic with no sense of panic, keeping their investment strategy moderately favoring equities over bonds.

They may well be complacent -- a U.S. debt default could trigger market chaos that eclipses the collapse of Lehman Brothers in 2008.

But if investors are right in believing that U.S. lawmakers will strike a last-minute deal, they will find themselves ideally placed to embrace a rally in risky assets toward the end of the third quarter.

"I do not see any solutions to the debt problem in any part of the developed market economies anytime soon, but I do see fudged deals on the current live issues," wrote Bob Janjuah, head of tactical asset allocation at Nomura.

"I think risk markets may surprise to the upside over the fullness of August. And I would not rule out an overshoot, into September."

He expects the S&P 500 index to rise to 1,350/1,370 over the next four weeks and the yield on U.S. 10-year Treasuries to rise to 3.4 percent.

Taking hedge fund positioning as a guide, they have been reducing equity exposures but have not yet abandoned their longs.

A Bank of America Merrill Lynch survey showed the ratio of hedge funds gross assets relative to capital rose to 1.5 in July from 1.27 last month, while their net exposure to equity markets -- measured as long minus short as a percentage of capital -- fell to 31 percent from 35.

JP Morgan's analysis shows a similar result, in contrast to last year when macro hedge funds moved to a short equity position.

"This contrast likely reflects a consensus view that, in a repeat of last year, an economic rebound will help push equity markets up, giving hedge funds a much needed performance boost," JP Morgan said in a note to clients.

Next week's U.S. releases including the Federal Reserve's beige book and durable goods and second-quarter growth data should help determine the scale of the H2 rebound. The world economy is still expected to grow by a healthy 4 percent this year.

Default Nonchalance

Even as the clock ticks toward an August 2 deadline to raise the United States' $14.3 trillion debt ceiling, many mainstream investors appear to be without any contingency plans to cope with the effects of a potential U.S. default.

Illustrating their nonchalance, fund managers polled by BofA this month did not even list the U.S. default risk as one of their top five biggest tail risks.

The cost of insuring the United States against default stands at just 55 basis points, nearly half the March 2009 peak.

"We just don't expect a default. The consequence of that is unthinkable. The U.S. government, in my opinion, is well aware of what the too-big-to-fail means after they let Lehman go, and that is peanuts compared to a U.S. default," one manager of a continental European fund said.

Even in the event of the United States losing its triple-A status -- of which Standard & Poor's said there was a 50-50 chance -- the lack of alternatives elsewhere may encourage investors to stick to Treasuries, mitigating the effect on financial markets.

The Federal Reserve has for the past few months been working closely with the Treasury ironing out what to do if the world's biggest economy runs out of cash in August.

But only a handful of firms -- including Morgan Stanley and Chicago-based cleaning house CME Group -- have publicly said they have contingency plans.

[Source: By Natsuko Waki, Reuters, London, 24Jul11]

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