In true New Year tradition, we have seen a slew of prognostications being made about the major market themes for 2012. The Mayan calendar and the prophecies of Nostradamus have certainly added intrigue to this mix. The financial crisis of 2008 is entering its 4th year, and regardless of the prophecies of doom, some of the outstanding issues will be resolved in 2012, one way or another.
Let us take a look at some of the major themes being presented for 2012, and my opinion on the risks associated with these themes.
European Sovereign Debt Crisis
Clearly 2011 has been driven by the tug and pull of every market speculation and the ensuing countermove by the European Union finance ministers and the ECB. But 3 years later, nothing has been resolved. The path of austerity adopted by the European governments which involves the sale of assets, public sector reforms and increased participation by the private sector are long-term solutions which will take years to play out. As the governments in Europe adopt severe austerity measures, we’re witnessing shrinking GDPs across the European continent. This growth reduction will affect corporate earnings, which will translate into lower stock prices. There is no way around this, unless the ECB decides to stimulate growth by printing euros and thereby devaluing the single currency on a large scale.
Therefore, if the ECB continues with its band-aid measures and stiff fiscal austerity, we will see the European stock markets correct by 20% to 25% in 2012. Conversely, if the ECB realizes that the only short term solution to Europe’s growth and fiscal issues is to print more euros and thereby devalue the currency, then we could easily see the euro head to parity against the US dollar.
Gold Rising To $2,000-$2,500 An Ounce
The majority of the predictions are coming in between $2,000 and $2,500 an ounce, but I have even seen some as high as $4,000. Clearly the predictions are a thematic extension of the 15% gains we saw in gold in 2011 as well as the bull market since 2002.
The major risk to the bullish scenario for gold in 2012 is the new found mantra of fiscal austerity being adopted by central banks around the world. Europe has suffered its sovereign debt crisis and is not willing to embark on any new fiscal stimulus; Asia has been raising interest rates to slow growth and curb lending; election year in the US with a divided Congress means that the probability of any fiscal stimulus is low. Gold’s biggest allure is that it serves as a hedge against devaluing fiat currencies. That is why the pace of appreciation picked up sharply since the crisis of 2007. If fiscal austerity does play out, I see Gold headed lower not higher in 2012.
Iran, The World’s Most Influential Rogue State
The International Atomic Energy Association recently announced that Iran has mastered the critical steps needed to build a nuclear weapon, with the aid of North Korea and Pakistan. This combined with Iran’s threats to shut down the flow of oil through the Straits of Hormuz certainly has added an element of uncertainty to the price of oil in 2012.
Based on the slowing global growth, oil should be trading closer to $75 rather than $100. This $25 premium is attributable to the threat stemming from Iran. If Iran crisis worsens we could see WTI oil rise to $130 quite easily, but the gravitational pull of slowing global growth will continue to pull oil towards $75.
U.S. Municipal Bond Defaults
Meredith Whitney grabbed headlines last year as she predicted massive municipal bond defaults. Her analysis was based in the speculation that slowing growth would lead to lower tax revenues for the states, which would lead to defaults. While we did see some high-profile defaults -- Jefferson County, Alabama, for example -- the total municipal bond defaults for 2011 came in at $2.1 billion, compared to $2.8 billion in 2010. Furthermore, the municipal bonds rallied and returned nearly 10% of potentially tax-exempt returns for 2011.
I feel that Meredith Whitney’s analysis was still correct, but off by about a year. Municipalities managed to meet their debt obligations by dipping into their reserves in 2011, and the US economy, while slowing from 2010, still managed to grow at a little over 1%, which provided some tax revenues for the municipalities. US growth remained positive, in my opinion, because of the tailwind effects of QE2 and also the new bond buying plan instituted later in the year.
Chances are high that the municipalities will face much tougher fiscal problems in 2012 as the Fed comes under pressure to refrain from any further quantitative easing plans in an election year.
Asian growth driven by China and India slowed markedly in 2011. Both these countries were fighting inflation and raising interest rates to slow demand. They also suffered from a slowdown in exports to Europe and the US. Consequently, both the Indian and the Chinese stock markets fell quite sharply and underperformed the US market. Will this trend change in 2012? Most likely not, especially if the global growth does not pick up as most emerging markets are nothing more than a high beta play on the US markets.
There are quite a few other unknowns facing us in 2012, and their outcomes are very hard to predict. Some of the most prominent macro money managers got it quite wrong in 2011. Pimco's Bill Gross got the direction of interest rates wrong, while hedge fund billionaire John Paulson had the worst year of his career. So what is an investor to do? Government bonds are paying next to no yield, and as I have stated above, municipal bonds are a risky proposition. Stock markets domestically as well as abroad have performed poorly, and the only constant that can be predicted for 2012 is a continuation of volatility with an increased possibility of sharp unexpected moves.
The world of investing has changed quite dramatically over the past few years. Buy-and-hold mutual fund-type strategies have not worked in over 10 years. Making predictions about a coming year based on the best macro-economic analysis also does not work on a consistent basis. The investing world is becoming very fast-paced and technical. Some of the strategies that have worked in the past, and in my opinion, will continue to work, are pure trading strategies that are driven by systematic algorithms, rather than human emotions.