As we start the last month of the first quarter, the investment outlook is decidedly muted. The storms of the Global Financial Crisis and the massive rebound from March to December of last year have past. Now, we investors look nervously to the horizon to see what is coming next.

On the positive side for asset values, there is no political appetite for pain in the financial markets. Interest rates will be kept at very low levels and liquidity will keep flowing to favored financial institutions. A simple teardown of last year’s numbers for Goldman Sachs suggests that interest expenses averaged 1.3%. Had they been compelled to pay an average interest rate of just 4%, 2009 operating earnings would have been wiped out. When compared with what consumers and small businesses are being asked to pay for credit, if available at all, it is clear that governments are going to do everything in their power to ensure that the major financial players are profitable.

On the negative side, cracks are forming in the public sector defenses that the major economies have put in place. The Euro has received the most press because of the Greek situation. But, the real problems appear to be brewing in China.

Let’s start with why Greece does not spell the end of the Euro. First, it is a small part of the European Union both politically and economically. For Germany and France, the breakup of the Euro is not a political option and they will accept unpalatable solutions (a bailout). It will be painful for Germany in particular because there is little doubt that a Greek bailout will prompt other countries to ask for support. Who’s next? The Spanish ETF (EWP) is dragging at the bottom of several portfolios. Will hedge funds manage to pound the Euro down to parity with the US dollar? The Euro ETF (FXE) is right down in the basement with the Spanish ETF while the US dollar bullish ETF (UUP) is our top ranking currency ETF this week.

Now why worry about China? After all, it is sitting on a huge pile of forex reserves and is able to lecture US Treasury officials while its economy grows at a stunning 8% clip. The issue is how China’s 2009 growth was achieved and how much longer it can wait for the US import machine to start up again. Last year’s growth was driven by massive state directed lending which has led to “see through” office buildings in Beijing (within sight of policy makers). Already there are indications at the provincial government level that some of the taps have been turned off and that this year’s new lending volumes cannot possibly keep pace with last year’s. With export growth still well off the 2007 pace, is there any wonder why the Chinese are not keen to raise the valuing of the RMB? The Shanghai Composite is close to breaking through its 200 day moving average, a warning sign for the local market as well as other Asian markets (Hong Kong, EWH, in particular). The main China ETF (FXI) is at the lower end of the rankings for our international portfolios. When will things turn around for China? The first indications will come from the commodity sector. After falling in the first weeks of the year, commodities appear directionless for the time being.

So what should investors do? Hiding out in cash is not indicated right now. In general, we are seeing more strength in the US markets (flight to safety?) and select emerging markets relative to developed Europe and Asia. In terms of sectors, a number of portfolios are still picking up strength in Pharmaceuticals (XPH), Health Care (XLV) and Biotechnology (XBI). The US consumer sector still has momentum in it but with high unemployment likely to persist for several more quarters, this may just be a reaction to US 4th quarter GDP numbers, which were due to inventory restocking, or hope that this year’s 4th quarter will be the start of sustainable consumer growth. US GDP growth is likely to be lower for 2nd and 3rd quarter.

In fixed income, there was strength in US Treasuries this week as some investors decided to hide from the mess in the EU and UK but the strength going forward is in Corporate High Yield. Some of that strength is coming from the money center banks and hedge funds that are looking to pick up yield in assets that can quickly be shipped over to the FED if liquidity becomes a problem in the future.

Commodities are directionless. Some of our more sensitive portfolios suggest that Gold might make a small move (the GLD/SLV trade looks set to push back in Gold’s favor) but industrial metals are becalmed as we noted in our section on China. Oil is struggling to break through $80 resistance as slack economic demand and normal political instability have balanced out bulls and bears.

As for currencies, the only interest (one could hardly call it excitement) is in the US dollar (UUP)and Japanese Yen (FXY).

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