Here are some of the main macroeconomic themes for 2012:
Geopolitical unrest will further increase in the upcoming year. A main contributor to the growing uncertainty and geopolitical risk will be Iran, as it is expected to obtain nuclear capabilities within the next two years. The International Atomic Energy Agency (IAEA) report in the second week of December may mark the turning point that will eventually lead to an armed conflict. Regardless of this report, escalation is looming in 2012. The risk of a nuclear Iran is too severe for many nations as it undermines the balance of power in the Middle East.
A military action or the threat of one will push energy prices higher, threatening economic growth in Emerging Markets such as China, and will push inflation higher globally. This raises the risk of stagflation in many eurozone countries.
The Saudis are likely to try and offset these pressures by increasing production, as well as use of global reserves. However, based on previous oil crises, we can expect this to have severe global implications. The “Green Economy” on the other hand will benefit from a new surge of investment, as we are about to be reminded of the importance of energy independence.
The eurozone crisis
The eurozone crisis is here to stay. There are two core problems facing the eurozone, the first stems from a lack of competitiveness and its inability to sustain growth and employment by issuing a regional economic policy, and the second, is the loss of capital markets' confidence in economic policies. For the past year, we’ve witnessed rate hikes while the periphery countries needed a monetary expansion. The imbalances within the euro are severe, while the surplus countries have presented limited will to share the costs of adjustment.
The second problem facing the euro is the pure loss of credibility by capital markets. Capital markets respond to deficit and debt in an asymmetric way. For decades, debt and deficits in developing countries were associated with higher borrowing costs compared to debt in developed countries: The U.S. from 2001-2003, Japan since the 1990’s and the U.K. since 2001, are all good examples of rising deficits and debt levels and diminishing borrowing costs. The higher costs that capital market are pricing for the eurozone countries, reflects their lack of credibility in the union. It is up to policy-makers to come up with a plan that will provide investors’ with confidence. But can eurozone leaders come up with a plan that will provide assurance to capital markets, yet at the same time will not promote moral hazard by investors as well as governments?
The only real solution is a fiscal union. However, the process of reaching full fiscal union (assuming this will gain domestic support, which is highly unlikely) will take too long a period, and countries will opt out before such a process can be completed. In addition, since establishing a fiscal union in the current format will prove unsustainable, we would undoubtedly witness certain members withdrawing from the union.
Nevertheless, we are hurriedly reaching the resolution stage, in which the stakes will become too high and action inevitable. We are likely to reach a temporary solution prior to the inevitable breakdown, in which Germany will gain greater control over domestic budgets in exchange for ECB/ IMF balance sheet support for struggling nations. It is important to keep in mind that despite the initial euphoria that we can expect to witness, following some eurozone leaders resolution, this will not provide a long lasting solution to the euro crisis. The economic conditions in the periphery countries are far worse than imagined, mainly with regard to unemployment. Spain and Portugal are exceedingly vulnerable, and social unrest is looming therein.
Furthermore, any agreement to save the euro will require a transfer of funds from the core to the periphery and will undermining the core countries’ triple “A” rating. In this respect, France is particularly vulnerable.
The main theme for 2012 is that high volatility in the eurozone is here to stay. Firstly, because the periphery countries will continue to struggle with pro-cyclical austerity measures, recession and rising unemployment, and secondly, due to policy-makers’ inability to sustain investors’ confidence. We can anticipate the smaller economies, such as Portugal and Greece, to depart from the euro first, as their only way of achieving growth facing with severe austerity measures is via export. In order to improve their trade performance, these nations can lower their labor costs by 30%, which in the current environment will be unmanageable, or devalue their currency. On the monetary front, we can expect a change of policy from the ECB. The ECB is likely to cut rates throughout 2012, and we shall see a more accommodating policy on its side, at the expense of the ECB’s credibility. Overall, we can expect real negative rates and high volatility.
The American economy will experience higher growth than expected in 2012 and 2013. Domestic consumption and investments will rebound sooner than estimated and overall GDP yearly growth will rebound in 2012-2013. Additional downgrades by rating agencies are still likely, but they will be similar to the recent downgrade that resulted in a 7% appreciation in the value of the U.S. dollar, and will not bear a real impact on the economy. Nevertheless, the implications of a downgrade on the banking system should not be ignored.
The Americans are likely to prove that their military and international hegemony is still intact with regard to developments in the Middle East.
Iran will become yet a more dominant theme within American politics.
With high unemployment rates and rising geopolitical risks, the probability of witnessing a change in government in 2012 is rising.
The shift in the balance of power towards the East implies a global economy that is increasingly dependent on China. Chinese growth will not be exponential, and we are likely to see the economy cooling off this year. Despite China’s rising power, the Chinese have no desire to take on a dominant role in international economic affairs such as the eurozone crisis or the Iranian threat.
Despite a short-termed economic cool off, we are not about to witness a hard landing of the Chinese economy. China is in an overall stable position, with adequate reserves to manage potential crises. Overall, the Chinese will continue to focus on strengthening domestic demand.
Nevertheless, risks are mainly on the downside as conditions within the eurozone will deteriorate and the geopolitical arena experiences further agitation. Iran’s development will undermine China’s growth prospects, leading to higher inflationary pressures. Additional downside risks are China’s local government investment vehicles and possible reduction in the level of investments, which can slow down the economy. On the upside, China’s industrial revolution should boost demand for commodities, and urbanization and development will continue throughout 2012.
Volatility and regulations
As the euro crisis will evolve, volatility will remain a key theme throughout 2012; policy-makers are likely to respond by imposing firmer regulations (such as the Tobin Tax and the Chilean pension model), and may even impose capital control. While this will take place primarily in Europe, we will certainly witness a ripple effect outside the continent, with the Singapore, NY and Hong-Kong financial service industries being the main beneficiaries. Firmer regulation on the financial sector will also undermine the U.K.- EU relations as the former has a clear interest in maintaining London’s status as a financial centre. We are also likely to witness a transfer of “risk” from investment banks to hedge fund, as banks will be required to adjust to new regulatory requirements.
New FX rules
The MF model, arguing that economies cannot control their exchange rate and have capital mobility and monetary autonomy all at the same time, has been tested in this crisis. Central banks intervention, in small open economies, proved that the MF model does not apply in a case where a central bank's aim is to devalue its currency. We can clearly observe that both Switzerland and Israel have intervened in the FX Market successfully, improving their terms of trade. We can expect to witness other small, open economies to follow in their footsteps in 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.