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The big market change will come when faith in government is lost [ClearOnMoney]
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The big market change will come when faith in government is lost

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Commentary

The big market change will come when faith in government is lost

20 Jul 2011 by Jim Fickett.

Many governments are succeeding, for now, in postponing very difficult adjustments. When one or more of these brittle situations breaks, and investors lose confidence in the ability of governments to maintain the status quo, there will be a sea change in market sentiment.

On Tuesday Bloomberg reported that the Quantum Endowment Fund (under Soros Fund Mangement) was 75% in cash, and quoted Soros himself as saying he was perplexed by the current markets:

“I find the current situation much more baffling and much less predictable than I did at the time of the height of the financial crisis,” Soros, 80, said in April at a conference at Bretton Woods organized by his Institute for New Economic Thinking. “The markets are inherently unstable. There is no immediate collapse, nor no immediate solution.”

Fund managers are quoted in the article as saying it is government intervention that is making the situation inherently unpredictable.

Part of the uncertainty stems from the fact that so much of what happens in global markets is dependent on government actions, which can distort prices and affect supplies.

“Most of our funds are in an uncomfortable position in that the fundamentals are bearish, but the governments are intervening,” said Harold Yoon, chief investment officer at Hong Kong-based SAIL Advisors Ltd., which invests in hedge funds on behalf of clients.

In my view many governments are fighting battles they must eventually lose – the Chinese are hoping to keep growth at unsustainable levels by putting more and more borrowed money into useless projects that will not pay it back; Europe is trying to hide the extent of sovereign insolvency and put off the day of default; the US and Japan are trying to ignore eventual insolvency. As long as this situation prevails, markets will be torn between the short run, in which policy actions kick the can down the road, and the long run, when fundamentals will prevail.

The sea change will come when one or more governments lose control of the situation – Japan defaults, US interest rates rise, the EU periphery defaults spread to the core, or China's growth stops supporting the commodity exporting countries of the world. The key will not be the event per se, but the loss of faith in the ability of governments to paper over the difficulties. Imagine the effect on sentiment, for example, if next month (1) several European banks were to collapse from CDS liabilities associated with a default in Greece, and (2) the Fed found itself unable to stop a spike in US interest rates due to a debt-ceiling crisis.

I do not not know when governments will lose their fight with irresistible forces, but I think they will, and at that time the investor confidence that is keeping asset prices high will be seriously shaken.