We'll start with the likely bearish market movers, because the balance of fundamental evidence remains negative for 2013, both for the consensus view and for ours.
MARKETS OVERBOUGHT, LIMITED UPSIDE AT YEAREND PRICES
At 1426, the bellwether S&P 500 is less than 7% from its decade highs of around 1526 last seen in July of 2007. However the fundamental picture is far darker. Remember that back then the global economy was doing fine.
- All major economies were expanding and expected to continue to do so
- Western housing and banking sectors were considered healthy
- There was no debt crisis in the US or Europe. No annual debt ceiling debate in the US. No quarterly threat of Greece/Spain/Italy becoming insolvent
Now the situation is reversed, yet most risk assets like the S&P are back near these decade highs due to unsustainable levels of government spending and debt fueled by money printing rather than real wealth creation.
Indeed, the near term bullish factors are short term anticipated relief rally from anticipated forms of stimulus in the US (fiscal cliff and debt ceiling deals that defer most of the planned spending cuts or tax increases) and Japan. Of course these events could also just become occasions to take profits as markets "sell-the-news."
Indeed the consensus is that the S&P remains within about 200 points, 14%, of its year end close.
FUNDAMENTALS WEAK FOR FORESEEABLE FUTURE
Other than anticipation of more stimulus in the US, Japan, the EU, China, etc. what else could justify higher asset prices?
The overall fundamental picture remains bleak for at least the next 6 months. When analysts say they don't see improvement until another half year, that often is just a polite way of saying they don't know when thing will improve. In particular:
Stagnant Global Growth: With the exception of China, growth in most of the developed world remains modest-to-flat, with ongoing contraction in much of the EU. The IMF has cut its global growth forecasts for 2012 and 2013, Per RBC Capital Markets Chief Economist Tom Porcelli, the PMIs of about 66% of the world are negative, meaning that companies expect lower growth ahead.
Real Incomes Are Flat Or Falling. For the gory details see here, here, and here. While consumers can draw down savings or take on more debt to temporarily sustain spending, that means economic growth and the revenues of anyone that sells to consumers (or who depends on those who do) will fall.
Stagnant Corporate Earnings Growth: With global growth weak (especially in the developed world) and the benefits of cost cutting largely exhausted over the past years, top line sales growth isn't happening yet. Until developed world consumers see real wage growth or EM consumers increase spending, growing those sales remains a challenge.
EU SOLVENCY CRISIS NOT PRICED IN
This is arguably the biggest oversight of all given that the EU crisis is still by far the biggest threat to global markets and remains the chief market mover. For now, the US fiscal cliff and slowdowns in China and elsewhere are only recession threats. However the EU presents multiple realistic chances of a major sovereign or bank insolvency that risks another market crash as bad or worse as what followed the Lehman Brothers bank collapse.
We have yet to see a solution that would prevent this.
While the EU has gotten faster at providing temporary fixes, there has been virtually no progress on any kind of permanent solution for the current crisis or for how to prevent one in the future. Solvency issues for the GIIPS have merely been deferred by essentially doing nothing but lending more to those who can't repay even their current debt levels, and promising to lend more printed money for as long as needed. We've discussed in depth what needs to be done. Yet markets continue to behave as if these steps are long term solutions rather than temporary band aids. For a full guide to distinguishing real solutions from the usual temporary measures, see here.
Even ECB head Mario Draghi himself admits that the EU has done nothing thus far but buy time, yet markets remain near the same decade highs that prevailed before this very real and ongoing threat, and so clearly aren't pricing in any risk future solvency crises.
That doesn't make sense. Neither Greece nor Spain have even begun to recover, and so remain likely to remain solvency risks.
Spain remains the next likely flash point, as discussed here, and there is no agreement in place on conditions that would allow the ECB to provide aid via its OMT program. Meanwhile its economy continues to deteriorate and capital continues to flee the country. There are other legitimate crash risk scenarios from the EU for 2013. For example, persistently bad data with no end in sight causes markets to lose patience, and begin a profit taking run that metastasizes into a full blown plunge that the ECB can't control. See here for details.
Whatever the scenario, the EU also faces two major elections this year in Germany and Italy. These will limit the flexibility of leaders in both nations. German candidates can't be perceived as too soft on the debtors, and Italian candidates can't appear too willing to yield to austerity demands from Germany and other funding nations.
Meanwhile popular support for the EMU is declining. How long can voters of debtor nations continue to accept austerity and the recession it brings, when it's not even clear that these policies are working? How long and creditor nation voters continue to accept making gifts to the debtors and risking their savings as the EUR risks long term debasement from excessive money printing?
For now the only question is when the next solvency scare happens and whether the past extend and pretend methods can continue to work for the coming year.
ONGOING U.S. AUSTERITY UNCERTAINTY
Washington's 11th hour fiscal cliff deal was essentially a repeat of the 2011 debt ceiling struggle.
Once again Washington showed it's dysfunctional and after much drama simply deferred the hard choices until the end of 2012 (hence this most recent fiscal cliff) and the debt ceiling was raised only a bit so that it would again have to be raised as of March 2013.
The just-concluded fiscal cliff negotiations also deferred most of the decisions on spending cuts, also until March 2013.
In other words, now we have another budget debate that is at least as important as the past two. If these were any guide the result is likely to be only minor progress on the deficit, and yet another temporary deal that sets up yet another budget struggle and month or so of uncertainty.
The big question here is, will markets remain overall steady and expect a deal, as they did for most of the past 6 weeks of fiscal cliff headlines? Or, will risk asset prices plunge, as they did in the summer of 2011's debt ceiling struggle?
Unfortunately, there's good reason to believe the latter result is more likely. That's because, in essence, both sides in Washington had a shared incentive to avoid getting blamed for allowing the full fiscal cliff to suck $500 bln out of the economy and knock the country back into a recession. However, Republicans and Democrats have differing agendas regarding raising the debt ceiling. Republicans want to minimize it in order to extract spending cuts and cut the deficit. Democrats want a big increase so that there is no further debate for a long time. See here, here, and here for details of what makes a smooth and responsible deal even less likely in the coming months, and why continued deferrals of the hard decisions are likely.
Also, we now have a series of "mini-fiscal cliffs" (budget, sequester, and farm bill) for which less is at stake and so not as much pressure to reach deal.
In sum, in 2013 we're likely to see more uncertainty on US debt policy (and possible solvency and sovereign credit downgrade risk) in addition to the periodic outbreaks of EU debt worries.
What's less clear is how markets react to it. Will they be scared like in the summer of 2011, blasé like they were over the past six weeks?
The Biggest Risk From Washington Is …Europe
Our take: these US debt issues only become really serious if they cause enough fear to rattle Europe and spike GIIPS borrowing costs. Washington has full control over its solvency, and can act quickly if both sides se real danger (and risk of voter wrath). However the GIIPS nations cannot fully control their own solvency risks and the EU is still too fragmented to act as quickly as Washington. Even the temporary fix of OMT aid requires that debtor nations agree to conditions they won't like and will fight to avoid.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.