A Late Summer Bounce

A late-Summer bounce is on the horizon for stocks, and other higher-risk assets if US government officials can follow Europe by solving or at least delaying a deeper crisis over growing government debt.
Broadly, asset managers have 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 US debt default could trigger market chaos that eclipses the collapse of Lehman Brothers in Y 2008. But if investors are right in believing that US lawmakers will strike a last-minute deal, they will find themselves ideally placed to embrace a rally in risky assets toward the end of Q-3.

The risk on markets may surprise to the Northside during and into the end of August, and you cannot not rule out an overshoot, into September.

The S&P 500 index target would be 1,350/1,370 over the next 4 weeks, and the yield on US 10-yr Treasuries sould rise to 3.4% or above.

Hedge funds have been reducing equity exposures, but have not yet abandoned their longs.

A Bank of America Merrill Lynch (NYSE:BAC) survey showed the ratio of hedge funds gross assets relative to capital rose to 1.5 in July from 1.27 in June, while their net exposure to equity markets, measured as Long minus Short as a percentage of capital, fell from 35 to 31%.

JP Morgan's (NYSE:JPM) 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 its clients.

The soon to be released US Federal Reserve's "Beige Book" and durable goods and Q-2 growth data should help determine the scale of the 2-H rebound. The World economy is still expected to grow by a healthy 4% this year.

Even the time counts down toward an August 2 deadline to raise the United States' US$14.3T debt ceiling, many mainstream investors appear to be without any contingency plans to cope with the effects of a potential US default, although India's central bank chief announced Tuesday that he has contingent plans for such a default.

Illustrating their nonchalance, fund managers polled by B of A this month did not even list the US default risk as 1 of their Top 5 biggest tail risks.

We just do not expect a default. The consequence of that is unthinkable. The US government IMO, is well aware of what the Too-Big-to-Fail means after they let Lehman go down, and that is "Peanuts" compared to a US default.

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

The US Federal Reserve has for the past few months been working closely with the US 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 (NYSE:MS) and Chicago-based cleaning house CME Group, (NASDAQ:CME) have publicly said they have contingency plans. Stay tuned...