Most hedge fund managers waited too long when the markets corrected sharply in May, preferring to stay long of the market. As European sovereign default risk rose in the eyes of the media and investors, investors began to revise their views. The popular press and newspapers like the Economist began to write about the tight spot that governments are in, caught between fiscal stimulus and having to pay for it. Many hedge fund managers turned bearish and reduced their long bets.

Markets are in their third day of positive territory. This is likely a technical rebound from a heavily oversold position at the end of June. However, there is another risk. Its all too easy to be a bear when markets are falling but the weaker the economic data, the more governments will have to abandon fiscal austerity and return to priming the pump. It may be a disastrous policy in the longer run but human beings are very short term in their outlook.

I would expect markets to carry the rebound through for at least another 2 weeks purely based on the technicals. If the economic data is sufficiently poor, I would expect policy noises to lean towards stimulus again. I would expect investors who previously penalized governments for profligacy to change their tune and look to them for fiscal support. This is likely to sustain the market rally into a multi month rally.

The risks are: economic data comes out more positive and therefore policy becomes increasingly hawkish, individual earnings miss estimates.

As Europe’s banks undergo so-called stress tests, an old adage comes to mind. Every failed trade becomes an investment. Every failed investment becomes a strategic holding.

Apart from specifying the nature of the stress, what is being assumed in each stress scenario, what probabilities have been assigned to sovereign default, etc etc, the valuation of assets and the assessment of the variability of the valuation of those assets is key in a stress test. Who is providing that valuation? Who is providing the assessment of variability and reliability?

Or is this a take home test?

Governments are torn between fiscal austerity and stimulating economic growth. Since credit driven growth ceased in 2008 private sector economic growth has been muted. Consumption has been hampered by the need to restore household balance sheets. Such restoration is likely to overshoot as the lessons of 2008 linger, so savings rates are likely to be higher than expected. Corporate investment is likely to be less robust as well as managers risk management is highly autocorrelated and corporates are likely to retain a high buffer of cash on their balance sheets. This leaves exports as the driver of growth. Not every country can be a net exporter.

Governments had been quick to pick up the slack left by private consumption and investment. This fiscal stimulus has left sovereign balance sheets stressed. A balanced budget approach to stimulus is not effective since it is only a reallocation of resources which may or may not be better than the status quo. Also, in the US, it is important to measure the net stimulus taking into account Federal and State policies.

The efficacy of fiscal stimulus is in the details. Should government cut taxes effectively outsourcing its fiscal stimulus to the private sector or should it directly engage in productive activities? The psychology of the consumer will likely drive them to save any additional disposable income they receive. Policy may be better served by government directly engaging in economic activity. It should do this in the form of building infrastructure and capacity for the future productivity of the country. There is the risk that government is a poor allocator of resources and that resource allocation is suboptimal. However, in the face of a private sector that is unwilling to deploy new resources, government is the best available solution.

The problem faced by most governments is paying for the fiscal stimulus. Governments with weak balance sheets may not be able to fund their fiscal plans. Their ability to fund their ongoing liabilities and operations may require them to operate a policy of fiscal restraint or austerity.

Economic policy is not one dimensional. While a government operates fiscal policy, its monetary authorities or central banks operate monetary policy, in the form of market intervention or determination of interest rates. In the acute liquidity crisis of 2008, central banks the world over increased the leverage on their balance sheets in an effort to prevent the failure of the financial system. They continued to print money in 2009 in an effort to compensate for the sharp decline in the velocity of money in circulation. This strategy works by inflating the nominal output of the economy but is unable to ensure that the nominal output increase is evenly distributed across all segments of the economy, and can thus be highly inflationary in certain sectors or industries, and is also unable to ensure that real output will increase, i.e. can lead directly to inflation. This strategy has worked to a certain extent and failed in others. In capacity constrained markets it has created inflation while in non capacity constrained markets it has increased real output. In particular it has caused asset price inflation in financial assets, which have now become acutely sensitive to monetary policy.

Monetary policy has its limitations. In developed markets, interest rates are already close to zero. In the absence of inflation, it is not possible to induce negative real interest rates. Fiscal stimulus needs to be brought to bear. The current issue is how to fund that stimulus. Since the beginning of May, Europe has focused on the ability of Greece to repay its debts. Similar concerns arose about Portugal and Spain. The likely outcome will be that developed market central banks will have to purchase sovereign debt thus inflating money supply substantially and accelerating the debasement of fiat currency. This is highly inflationary. High debt to GDP countries will likely favour this type of inflationary policy since they have few options and this option is least worst.

Inflation, however, is measured with a CPI or RPI. The mechanical and defined specification of a price index can hide or degrade information. Owner’s imputed rent features significantly in most inflation measures, yet is never paid, and thus has little income effect. It is likely that inflation may be underestimated for some time while eroding real incomes and purchasing power. Inflation can occur not only in goods markets, service markets, but in the market for future claims on goods and services, in other words, the asset markets.

The future direction of asset markets whether equities, credit, commodities or real estate is likely to be highly sensitive to economic policy. While global growth remains fragile and uncertainty is high, economic policy will have a high impact on prices. Only when certainty returns to the global economy will idiosyncratic risk return to markets.

In economic policy there is a difference of view between the US and the rest of the world. As Japan’s largest trading partner the US is especially empathic to the deflation scenario that has plagued Japan since 1990. Therefore, US monetary policy is likely to err on the side of being too loose rather than vigilant on inflation.

Europe has a history of hyperinflation and is therefore likely to tighten sooner than might the US. The current focus on the health of sovereign balance sheets strengthens the case for a retraction of quantitative easing and expansionary fiscal policy.

The flexibility of the CNY is likely to reduce the demand for US treasuries and lead to a de linking between US and China monetary policy. China economic policy will be more hawkish on inflation than before.

All these point to the resumption of de risking that began in May that has led to falling markets and a rise in correlations.

This is all backward looking.

The economy and markets have reacted to the financial crisis of 2008 and the subsequent stimulus policies quite predictably. It rebounded and rallied hard as governments printed money thus debasing their currencies and inflating the value of real assets and future claims on the cash flows expected to be generated by real assets, and quite a little relief and hope.

We have seen in past crises like the one in Asia that post the initial decline, 100% rallies are possible and post those, 50% retracements are also possible. Equity markets are technically weak. They may strengthen over the next few weeks as corporate earnings come in reflecting 2Q financial results, but the trend is down. Earnings, however, are not the driver of markets. Liquidity and policy are.

There are many factors that can drive equity markets over time, but there is usually only one or maybe two factors that drive them at any moment in time. Equity markets are likely to continue to fall until weaker economic numbers prompt policy makers to revise their stance on fiscal rectitude and start printing money again. Who will go first? The US has not tightened policy. Australia, Canada and Norway, for example, have already been running tight monetary policy for some time, since 2009. China has been selectively reigning in leverage in particular sectors of the economy to prevent overheating. The commodity countries and Asia are unlikely to loosen policy again soon. The more likely candidates for reverting to expansionary economic policy are the Europeans on the basis that European economies are likely to be weakest.

Germany is exposed to exports to Asia; a more domestic centric China will impact European exporters. Domestic Europe remains weak and disconsolate. Unemployment remains high, balance sheet repair is slow. Spain is in a depression. Greece is insolvent. The PIIGs face a liquidity crisis. The outlook for Europe is poor. Able or unable, Europe will print money. Interest rates will remain low and if anything head to zero. Fiscal policy is constrained which will put even more pressure on monetary policy.

Europe is likely to be the first to resume printing. And the debasement of currency has as its dual, the inflation of goods and services, and assets.