Stick to gold and equities, avoid bonds

While there’s always a chance of catastrophe, the odds of an all-out financial Apocalypse are pretty long, according to Jurrien Timmer, director of global macro research and portfolio co-manager of the Fidelity Tactical Strategies Fund.

In a recent webcast, he explained why he’s overweight equities and precious metals at the expense of investment grade bonds.

“This sounds maybe a little corny but my outlook is partly sunny with a chance of Armageddon,” he said. “What I mean by that is we’re actually fairly constructive over the short to intermediate term, in terms of the risk markets—equities, credit and commodities—but obviously there is significant tail risk out there—Europe, the U.S. debt ceiling, and a hard landing in China.”

Timmer singles out the U.S. debt ceiling as particularly critical. “There may be only a 1% chance of a technical default, but if it happens it’s a catastrophic occurrence. This is where the chance of Armageddon is and it prevents us from allocating more to the risky markets than we have. It also keeps us in precious metals as a hedge against the potential that the central bank will ultimately have to essentially monetize debt.”

The recent “soft patch” in the U.S. market has been due at least in part to the earthquake and tsunami in Japan back in March, Timmer said. “But industrial production is coming back very strong—their latest number was the strongest in 50 years, so our contention is the economic slowdown will reverse at least in part. We may not go back to 4% growth but we should be able to go back to 2.5% or 3%, and that’s probably enough for the markets to recover.”

Euro and U.S. debt

While he doesn’t dismiss the risk posed by Europe’s sovereign debt crisis or the U.S. debt ceiling issue, Timmer suggests doom and gloom headlines should be taken with a grain of salt. “My assumption is ultimately they will be forced to make some sort of deal that satisfies the markets, and we will look back on this as a buying opportunity,” he said.

Timmer notes that for countries running large debt loads there are only a few ways out.

“Ideally you grow your way out, and that’s what the U.S. did after WWII,” he said. “The problem in Europe is Greece can’t grow its way out because it doesn’t have a competitive economy—you can only export so much olive oil—and because the troika of the European Commission, IMF and ECB are basically forcing austerity on Portugal, Greece and Ireland. It’s very hard to grow when you have austerity.”

Typically, when a country like Greece has a lot of debt, it will do what countries in Latin America—and Greece itself—have done in the past: devalue the currency and inflate its way out.

“The problem with Europe of course is that there’s a single currency and a single central bank. So Greece and other [eurozone] countries cannot inflate their way out because they have this anchor tied around their necks,” Timmer explains.

There are really only two ways out for countries like Greece.

“One is what we used to call default, but now call restructuring or rescheduling, where instead of a 5-year bond at 3% you get a 30-year bond at 4% or something along those lines—something where the holders of these bonds don’t have to take a haircut, or at least not a significant one, and where it doesn’t trigger the credit default swap markets.”

The other option is for the ECB or the EFSF to buy the bonds nobody else wants. In other words: debt monetization.

“My guess is that we’re going to have a combination of both. But it’s inevitable that somebody is going to have to buy this debt, whether it’s the ECB, the EFSF or maybe China. China is sort of Europe’s white knight—they want to make sure the Euro stays viable,” Timmer said, adding that taking these measures should make the landing relatively soft.

“They’ll kick the can down the road but that’s how these problems get solved. There’s an old saying, ‘A rolling loan collects no loss,’ and essentially this is what happened in Latin America—you restructure your debt, somebody takes a haircut and you call it a day. That’s what I think has to happen here. The only question is how bad do things have to get before the ECB truly blinks and starts expanding their balance sheet again. And I think we’re either at that point or very close to it.”

Unlike Greece, the United States is in a position to debase its currency. “We’ve done it in the past, we’re doing it right now, and we will probably do it in the future. This is why we are underweight dollars and overweight precious metals,” Timmer said.

He suggests we can probably expect another week or two of political posturing in the debt ceiling negotiations, but an agreement will in all likelihood be reached. That deal will likely fall well short of what both the Republicans and Democrats are demanding, and will probably involve “$1.5-trillion to $2-trillion in spending cuts back-loaded over a very long period of time—about 10 years. It’s not really going to accomplish anything in terms of entitlement reform, which is really what we need to address our large deficits. I think they’ll kick the can all the way down the road into the gutter.”

“I think there is a 99% chance it will be resolved this way. There’s a 1% chance we’ll actually go into default and have a crisis. But 99-to-1 is good odds and that’s why I don’t want to be putting your money under the mattress right now.”