To evaluate the likely top market movers for 2012, the top considerations were:
- Likelihood of occurring in 2012
- Impact on global economy if it occurs
Our overall conclusion is that the global economy this time next year will be anywhere from stagnant to deep recession, depending mostly on whether the EU avoids a breakup, orderly or otherwise, in 2012. The global economy remains mired in a process of shedding the debt that has fueled much of the growth for the past 30 years. The process is necessary, unavoidable, and bearish for the coming years. Here are the chief concerns for 2012.
EU: Sovereign Debt And Banking Crisis
A slowdown appears likely, but can the EU avoid a crisis?
Likelihood of occurring in 2012: High for slowdown, medium for crisis
Impact: High
Yes, plenty of other black swan events are conceivable, but the EU remains the most likely source of trouble and market moving events. Specifically:
Specifically:
- If the EU can continue to prevent a major sovereign default, markets stand a good chance of ending 2012 flat to higher.
- If not, the most likely result is a banking and global economic crisis at least as serious as that seen in 2008 after the Lehman Brothers bankruptcy.
While some like Nomura Bank believe markets have partially discounted an EU credit event, we do not. As of the end of 2011 the bellwether S&P 500 is around 1260, less than 8% off its 2011 high of ~1360, and less than 13% from its all time high at around 1560. That hardly seems to discount the global depression risked by a wave of sovereign defaults. Remember, compared to 2008m the world’s economies are weaker and the developed world carried far less debt, particularly the public sector following assorted stimulus measures over the past years.
While we believe #2 will occur eventually, it’s impossible to say how long it can be deferred. That will depend greatly on unpredictable political decisions. The EU appears to be aiming for an “orderly default.” While the details of that are unclear, the term does suggest they’re aiming for defaults without market panic, asset price collapse, and bank runs. Theoretically that may be achieved via a clever combination of capital controls, bank holidays, money printing, and state guarantees of too big to fail (TBTG) institutions. We wish them luck. Too much more austerity risks an exit by the debtor nations, and any significant devaluation of the EUR risks an exit by Germany and possibly a few other nations committed to preserving the value of their citizens’ savings.
There are so many uncertainties and ways that this could play out.
While the modern world as we know as seen numerous defaults in peripheral economies, it has never experienced the potential wave of sovereign defaults that could occur. Unlike in the past, the 17 Euro-zone nations cannot print their way out of default, and are unlikely to ever be able to agree to do so. Germany and a few other relatively healthy hard money economies have shown no sign of willingness to accept being stuck with a drastically weakened currency. Even if they would, they’d demand a level of austerity and surrender of budgetary control that the debtor nations do not appear ready to accept.
A few weeks ago ratings agency Fitch publicly concluded what some senior EU and IMF officials have asserted anonymously for months: that the EU and EUR as we know it is beyond repair, given the low chance of member nations agreeing to a workable solution. We agree, but can’t say when the breakup comes or what form it takes.
2. China Slowdown
- Likelihood of occurring in 2012: Appears high though lack of transparency in China data adds uncertainty
- Impact : High
There are abundant signs of a significant slowdown in China, like huge residential housing projects sitting complete empty, collapsing real estate prices in second tier cities, etc.
The problem is that data out of China is notoriously unreliable. As the world’s second largest economy, it’s only large growth engine, and by far the largest customer of most industrial commodities, any slowdown here gets felt globally, particularly in commodities and the commodity related economies like Australia, Canada, Brazil, etc.
US Slowdown
- Likelihood: High for stagnant to worsening economy but the degree of decline depends greatly on what happens elsewhere.
- Impact: High
With the US, we don’t have as many uncertainties as with the EU and China.
Unlike the EU, there’s no threatened wave of sovereign and bank defaults without a central bank committed to printing enough cash to prevent it.
Unlike China, data is more transparent and reliable.
Data over the past months has been relatively good, leading many to believe the US can somehow decouple from slowdowns in the rest of the developed world. We disagree.
Weakness in Housing, Banking, Employment, & Spending Continue Slow, Self-Feeding Downward Spiral
The real estate/construction sector collapse, which radiated through banking and into the rest of the economy and brought the current slowdown, remains in effect. No surprise because we’re not in a normal cyclical recession. Were that the case, GDP growth would be running at more than twice its current levels, and unemployment would have fallen rapidly.
Instead, the official (and understated because it excludes those who’ve given up seeking work) 8.6%, U.S. unemployment continues to undermine consumer spending, the largest part of US GDP. Monthly Non-Farm Payrolls have averaged a gain of 108,000 for the past 15 months, inadequate to accommodate new jobseekers, let alone replace the ~6 million jobs lost (mostly to cheaper emerging markets) since the start of the financial crisis. The Labor Participation Rate fell to 64% in November, its lowest level since 1983 – hardly representative of a healthy economy. Data on the housing market is mixed, even before considering the hidden excessive inventory and record numbers of households swamped by negative equity, which suggests that further deterioration is equally likely.
Employment linked to real estate, construction, and related retail, together with housing equity withdrawal, boosted U.S. growth between 2000 and 2007. Without a significant improvement in housing, we don’t see how employment and spending will materially improve.
Corporate Guidance Bearish For Q4 2011 Earnings
We’ve had over 80 negative pre-announcements on earnings per share for S&P 500 companies from September to the beginning of December. This is the highest number of negative pre-announcements since the fourth quarter in 2008 and it includes marquee names such as DuPont, Texas Instruments, and Intel.
Cost cutting has helped earnings since the start of the financial crisis over three years ago. However, that fix is reaching its limits, particularly regarding staff cuts. US corporations continue holding cash hoards (despite low returns), because they don’t see worthwhile opportunities, at least not in the US. That lack of expansion further depresses America’s jobs, spending, and growth outlook.
Don’t be fooled by an upbeat Q4 earnings season. The lower guidance is part of the usual game. It will justify low-ball analyst estimates that will be more easily beaten, and the ‘surprising’ number of beats could justify some kind of rally. The high percentage of beats will likely be taken
US Debt Growing
Meanwhile US government debt continues ever higher. After a series of stimulus programs since 2008 the central bank’s balance sheet has grown from 500 bln to $2.8 trln.
While the US does not face an immediate solvency crisis like that of Europe. It can print money as needed and sell bonds as long as there are buyers willing to hold dollars. Still, it’s on the same path as Europe and Japan, and is showing no signs of addressing its own growing deficit. Congress remains unable to reach agreement on a long term solution, and is unlikely to impose pain on voters in an election year, or apparently at any point until a crisis forces a decision.
In addition, the Fed has committed to keep rates low until mid-2013, and the coming debates in Congress will be about raising the debt ceiling and extending the payroll tax cut. Both are likely to occur in some form given the coming election year.
Conclusions & Ramifications
Given headwinds from stagnant growth in most of the major economies, downside potential is far greater than upside, hence our bearish bias for 2012. So what do you actually do about it? We give a brief outlook for the following assets.
Stocks
As noted above, we expect slowing to declining growth in the EU, US, China. Japan and the rest of the BRICs face the same, and the UK looks almost as bad as the EU. In sum, at best we get a modest rally, more likely flat to lower, possibly significantly lower if the EU blows up. The major indexes will reflect this. Longer term investors should either play the downtrend with short plays and/or selectively by income top quality income stocks during panic driven plunges in order to generate some income with cash they don’t need for a few years. For what it’s worth, the consensus on Wall Street is that stocks close next year a bit higher. A recent survey of 16 top analysts’ targets for the S&P 500’s 2012 close produced a mean of 1367, with individual forecasts ranging from 1238 to 1500.
Again the big wildcards here are the EU crisis (bearish) and new stimulus programs (bullish). An EU blowup sends stocks down, stimulus from the US or EU gives them a lift.
Forex
While our overall bearish view suggests long positions in the safe haven USD, CHF, and JPY, that will only work if you’re taking 12 month or longer positions, and can handle lots of volatility during that time
EURUSD
Expect further attempts to shore up confidence about Spain and Italy in order to get their borrowing costs lower. If these fail, the Euro-zone and EUR as we know it is finished, most likely continuing with a reduced membership. That drama virtually insures that the EUR tests all time lows, probably close to parity.
CHF, JPY
The picture for the CHF and JPY is less clear, because both the BoJ and SNB are actively intervening, though markets eventually overwhelm these attempts, and will overwhelm them if the EU blows up. The CHF is our favorite long term long position, given the country’s solid finances. Japan, in contrast, with its record debt to GDP is a known disaster waiting to happen. However as long as its current account remains positive markets have been willing to trust it and buy Japan bonds, though everyone acknowledges this can’t continue forever.
Commodities
Oil
Flat to higher. Even with economic slowdowns, supply questions and geopolitical uncertainties suggest more upside than downside. Again, if the EZ blows up, expect oil, along with all risk assets, to dive.
Gold
Unclear. The trend towards easing among virtually every major central bank should be great for this ultimate fiat money hedge. However gold will struggle to recover in the coming year due to:
- Selling from those who piled into this trade too late
- Selling from those seeking cash in times of fear
- Low inflation concerns from low growth
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.
