The slow improvement of the U.S. economy, reflected in weekly jobless claims, coupled with QE2 is providing an underlying bid to the equity market, which is surprising to many, given the increasingly ugly global macro picture.  On the Western Front, bulls are fighting the negative forces of the implosion of Europe, which has contributed to a sharp rally in the dollar and a sell-off in financials stocks (see charts.).   If the announcement of Ireland’s rescue package fails to stabilize Europe, we suspect the correction will gather speed causing the S&P500 to test, at minimum the 50-day moving average at 1176, with stronger support at 1132, the 200-day moving average.

The battle on the Eastern Front is much more uncertain, however.   First, who can predict the actions of North Korea?   And what and how will the Chinese react?  Will they try and use the situation to diminish the U.S. role in region, allowing the conflict to escalate in order to argue that the American presence actually increases instability?   China’s tough stance and export embargo of rare earth elements to Japan during the diplomatic row over the detainee of a fishing boat captain earlier in year was both shocking and enlightening.  It was, for many political analysts,  the “coming out” of  a new and more aggressive Chinese foreign policy.

Second, the direction of China’s monetary policy, which has been pushed off the radar with the North Korea and the European debt crisis, is a key driver for commodities and emerging markets.  China is perceived as the locomotive of global economic growth and the tightening monetary policy to tame inflation only adds more uncertain to the markets.

Nobody knows how the macro picture will play out.  We are surprised how well the U.S. equity market is trading and believe it is because: 1)  the perception the economy is improving; and 2) a surge of global capital flows back to the U.S. market.   We’re on the cautious side with a  small long equity position hedged with S&P puts and larger long dollar position.  We’re keeping a tight stop on gold as it has not been trading poorly, which is disturbing given the increase in geopolitical tensions and the Eurozone meltdown.

Finally, the bond is not behaving normally and has failed to rally during this period of global uncertainty.  This may be confirmation of the economic recovery story, or that sovereign debt concerns are starting to spread.  We will discuss in further posts.  Stay tuned.