[private] Saturday 31st December – 2012 Forecast
It’s that time again when I stick my neck out even more than normal and set out my predictions for the next year. One of my friends tells me that my 2011 predictions were fairly reasonable – 2012, I suspect, is going to be much more challenging. I believe that 2012 may well be a year of 2 halves, with markets under severe pressure through the 1st Q (possibly 1st half) of the year, followed by a (potentially significant) rebound thereafter.
The global economy will continue to weaken further, in particular during the 1st half of the year, though I expect some stabilisation towards the year end. Historically, political instability rises during economic downturns, in particular in EM’s, as their economies deteriorate more so than DM’s. However, in 2012, DM’s will not be immune to political turmoil, particularly in Europe. Political tensions will clearly be market negative.
The global slowdown, combined with base effects and lower energy prices (see below), suggests to me that inflation should decline materially, in particular from the 2nd Q onwards, enabling Central banks worldwide to ease monetary policy further.
The BRIC economies will remain under severe pressure, as I see no respite for Russia, India or China, with political turmoil remaining elevated. Elections in Russia and a significant change in the Chinese leadership (which is to be announced in October next year, but does not take effect until the following March) will increase political concerns. A slowing economy, corruption issues, a deteriorating budget and current account position, weakening Rupee and continued political infighting does not bode well for India. The contraction of lending by European banks will act as a further drag on the BRIC’s and on Asia in particular, as will continued selling by equity investors and reduced FDI into the region.
I expect Oil prices (ex geo political issues) to decline in response to the slowing global economy, which will have a severe negative impact on the Russian economy, given its dependency on energy. The Russian authorities had increased spending ahead of the impending Presidential elections – state spending will increase further, given the recent turmoil. A combination of higher spending and lower oil prices suggests that Russia will post a budget deficit this coming year, which will add to the pressure on the Ruble.
As for Oil, I believe that Brent (ex geo political issues) will decline from the current US$108 to between US$80 – US$90 (quite possibly lower), sometime during the 1st half of the year, though may well recover towards the year end. I am not a fan of the energy sector in the 1st half of the year in particular, but M&A activity could well pick up materially. Lower Oil prices will certainly be of significant help to the global economies and will reduce inflation further.
I continue to believe that BRIC markets will continue to under perform, particularly in the 1st Q/1st half of the year, both in terms of equities and their currencies. Increasing capital outflows/flight from these countries, mainly into the US$, will add to the pressure on their currencies. There is a real possibility that the gradual rise of the Yuan will slow down to a trickle and, indeed, that the Yuan may even decline against the US$ during the course of the year – a particularly sensitive issue in an US Presidential election year. Protectionism and trade related matters will dominate headlines.
The Chinese economy will weaken further as problems in the property/banking/export sectors continue to plague the country. Further material declines in property prices and a large increase in bad loans are highly likely. Excessive provincial debt (which cannot be repaid as the provinces have relied on property sales in the past to fund their expenditures) and significant (and increasing) bad loans within banks will have to be dealt with, requiring a bail out by Central authorities. The amounts involved are huge, though data is unreliable, as usual. Their export sector will be hit by the accelerating global slowdown and, in particular, by the weakness in Europe – China’s largest trading partner.
Domestic consumption will not compensate for the decline in the rest of the economy – indeed, consumption may well slow, in response to the weaker economy. 2012 GDP growth could decline to around 6.0% or lower (Chinese official data is always suspect), which for China represents a material slowdown, given the previous near double digit growth rates. It is generally accepted that China must maintain GDP growth of around 8.0% to avoid unemployment rising to levels considered dangerous for political stability.
The Chinese authorities will be forced to recapitalise banks, bail out the provinces and, in addition, relax monetary policy much further. Overall, I remain bearish on China. Its economy, which was reliant on fixed asset investment and exports in the past – no longer growth drivers – suggests that the authorities have no easy option. The chances of a hard landing are significant, though the Chinese authorities do have significant resources at their disposal to ease the potential significant economic downturn. Expect talk of social spending in the coming year, though previous programmes have failed.
The slowdown of China, combined with a stronger US$, will be negative for the base metals (and commodity based economies such as Australia, which are reliant on Chinese growth) and I expect further declines in the share prices of the miners, particularly during the early part of the year. In addition, I remain bearish on the A$, particularly against the US$. The Australian property market appears vulnerable as well. The CAD should also weaken against the US$, but, I expect, will perform better than the A$.
Whilst I remain bearish of base metals/miners, I believe that agricultural commodities (wheat?) will perform much better next year.
There has been an increase in contract disputes/failure to pay suppliers by Chinese firms in general – expect this trend to increase significantly. FDI into China will decline significantly (a trend which will continue in coming years), as labour costs rise in response to Government policy, once again negative for the Chinese economy.
Chinese relations with its neighbours and the US, in particular (given the impending Presidential election) will remain fraught and, indeed, likely to get worse. The South China seas issue will remain a major and on going problem.
Loser monetary policy and market intervention around the time of changes in the political leadership (October next year), could contain some of the downside risk, though the fundamental problems and major imbalances of the Chinese economy remain a serious threat.
The US will be in election mode, with the campaign becoming increasingly vicious. Political gridlock will intensify, negatively impacting the US economy though unlike Europe, the US should report positive GDP growth for the year of around 1.0% – 1.5% – lower than current forecasts and with a downside bias. I expect the US economy to weaken as the year progresses, given the weaker global economy. With low GDP growth and a weaker global economy, unemployment in the US is unlikely to decline much further, though I don’t expect a surge in unemployment either. However, the US will remain amongst the best of a very bad lot, in particular in the 1st half of the year. Lower US GDP suggests than current analyst forecasts are far too optimistic and will have to be revised lower.
The FED may state that interest rates will remain low into 2014, as reported by the WSJ, though it looks as if QE3 is off the menu at present,. However, an explosion in Europe for example will get the FED moving.
I believe the US housing sector will start to stabilise by the end 2012, with a bottom in (maybe the 1st half of) 2013, though quite possibly sooner – a US housing recovery is the key to a future pick up in the US economy. In a number of cases, it is currently cheaper to buy a home rather than to rent it, given low prevailing interest rates. Yes, there is an on going problem with foreclosures and a large available housing stock and shadow inventory. However, most of these homes will remain unwanted and probably unsellable.
Increasingly, investors are buying homes to rent to obtain higher yields than that available on US bonds – in a number of cases these purchases, assuming continuing rentals at current rates, are self financing. I believe that purchases by investors will increase materially in 2012. Exceptionally low long term mortgage rates are a huge incentive. Existing homeowners will benefit from refi’s, which will increase disposable income, as will lower petrol prices. The payroll tax issue will be resolved – it will be extended through 2012, but the US will be subject to some fiscal tightening.
The US$ should strengthen further against the Euro – my forecast for the US$/Euro remains at US$1.20, quite possibly during the 1st half of the year, indeed likely even lower (sub US$1.10), which is negative for commodities and markets, in general. I appreciate it’s a crowded trade, but I see no respite for the Euro.
However, whilst I expect market weakness in the 1st Q/1st half of the year, I believe that US markets will recover thereafter and I expect (in Euro/Sterling terms, in particular ) returns of over 10% for the year, in spite of pressure on earnings – analysts forecasts will be reduced in the 1st half of the year, in particular.
Further austerity measures will result in the Euro Zone dipping into recession, with even Germany reporting close to zero or negative growth – the most recent German Government forecast of +1.0% 2012 GDP growth is optimistic in my view. The other major Euro Zone economies, namely France, Italy and Spain will decline, with Spain and Italy dipping into recession. It’s touch and go for France, though I suspect that France will also dip into recession.
I continue to believe that Spain has far more serious problems than currently recognised by the markets and remain amazed that Spanish bond yields are so much lower than their Italian equivalents. Spain announced yesterday that its 2011 budget deficit would come in at 8.0% of GDP, rather than the 6.0% forecast. What a surprise – I think not. The former Spanish Finance Minister, Mrs Salgado was more than just “economical with the truth”. As a result, I continue to believe that Spanish bond yields will converge towards Italian rates.
S&P is to issue updated credit ratings in respect of most of the Euro Zone countries in January (15th I believe) – expect downgrades, including for France and possibly even Germany. However, if Germany is downgraded, the chances of a 2 notch downgrade for France remains high. I suspect that of the Euro Zone countries, only Finland and Luxembourg will retain their AAA rating next year. However, with so many countries worldwide losing their AAA rating, combined with widespread anticipation of cuts in ratings, prospective credit downgrades will have less of an impact than would otherwise be the case.
A number of Euro Zone countries will become more and more frustrated at the continued downturn caused by the austerity programme (there are no growth policies in place), which leads me to believe that the ECB will be forced to act more vigorously, with interest rate cuts (totalling at least 50 bps – reducing the ECB’s benchmark interest rate to 0.5%) in the 1st/2nd Q’s and with QE in the 2nd Q, at the latest. Furthermore ECB benchmark interest rates will remain extremely low “for an extended period of time” to quote Bernanke. Indeed, interest rates will remain low worldwide for quite some time.
Ireland remains the only of the PIIGS countries to have stuck to its budget deficit targets, by the way. However, 3rdQ GDP/GNP highlighted the country’s problems. More austerity measures were proposed in the most recent budget. To date the population has accepted the cuts, but with other countries ignoring their targets, it will be difficult to persuade the Irish population to accept further austerity measures – proposed to be in place until 2015.
I remain of the view that the ECB will announce a QE programme in the 2nd Q 2012 at the latest, particularly if Euro Zone forecasts confirm that inflation will fall well below its 2.0% benchmark – which it will. The ECB’s mandate is to ensure that inflation remains “below, but close to 2.0%”. Towards the end of the 1st Q next year, inflation in the Euro Zone will start to decline significantly which, in my humble opinion, allows the ECB to introduce QE, dressed up as an “anti deflation policy”.
Whilst the German representatives at the ECB will be strongly opposed, they are losing support from their traditional allies Finland, Holland and Austria and, in addition, are just 2 (out of 23) voting members. Furthermore, I believe that senior German politicians have reluctantly “accepted” that QE is inevitable if the Euro is to survive. Lower interest rates, combined with QE and a much weaker economy, will increase the downside pressure on the Euro.
The recent E489bn of 3 year ECB funding for 523 banks is, however, a game changer – I remain amazed that the market has not understood this as yet. It is de facto QE, as money leaks out of the banks into the wider economy, though dressing up the ECB’s LTRO programme as providing medium term financing for European banks is politically more acceptable than traditional QE, particularly for the Germans.
A further 3 year LTRO auction is scheduled for the end of February and will, once again, attract a high take up. The introduction by the ECB of these liquidity measures has, in effect, dealt with bank liquidity issues for 3 years at the very least, though I suspect a number of Euro Zone banks are facing serious solvency issues, as well – the LTRO’s will avoid solvency issues becoming a serious threat the major European banks.
The injection of 3 year funding for European banks removes the threat of a systemic Euro Zone banking crisis, improves core tier 1 ratios (as banks buy back their debt which is trading at a discount), increases profits (once again improving core Tier 1 ratios) and, most importantly, buys time.
In addition, I would not be surprised if banks invest some (relatively small sums) of the funds obtained from the ECB into short term (up to 2 years) Euro Zone debt to play the carry trade, though I suspect they will shun longer term Sovereign debt issues. The question then arises as to who will buy Euro Zone bonds, in particular of Spain and Italy.
I believe that the ECB may be forced to issue bonds (Euro Bonds?) as it finds it more and more difficult to sterilise the proceeds from increasing purchases of peripheral debt, which I believe they will have to buy at a far greater pace in coming months – Italian 10 year bond yielding over 7.0% is simply unsustainable. However, the introduction of QE, possibly as early as the 1st Q, but more likely in the 2nd Q, removes the probability of the ECB issuing medium term bonds (Euro Bonds) I must admit.
Declining Euro Zone inflation could well be the reason cited by the ECB for the introduction of QE which will involve significant purchases of Italian and Spanish debt, in particular. Draghi would ideally prefer a binding agreement amongst Euro Zone countries on fiscal disciple in advance. However, the EFSF/ESM lack the necessary fire power necessary which will force the ECB to react much more aggressively in terms of its bond buying programme. As of 28th December, the ECB’s balance sheet soared to a record E2.73tr, increasing by E553bn in just 3 months – it will expand much, much further.
The recent Euro Zone “fiscal compact”, to be enacted through bi lateral agreements, is a non starter. Cobbling together agreements of this kind whose, inter alia, legality is questionable. Implementation fraught and politically difficult will not work. As a result, a continued crisis in the Euro Zone, starting in the early part of 2012 is a certainty. However, I believe that the Euro will survive – the alternative is much, much worse.
Funding issues for Euro Zone countries will remain a significant headwind for Spain and Italy, particularly in the 1st Q/half of the year. Greece, as usual, will not comply with its commitments, making it virtually impossible for the IMF to provide further bail out funds. Haircuts of over 75% on Greek debt, held by private sector investors, will be required. Whilst the IMF is a preferential creditor, I believe that the Euro Zone/ECB will also be forced to accept write downs on the loans they have provided to date.
Portugal will not be able to survive with its current debt load – a restructuring, involving a haircut of up to 40% on Portuguese debt is a near certainty.
I believe that the Euro Zone/ECB/IMF will finally get fed up with Greece and the possibility of additional bail out funds for the country must be questionable. I don’t know and, quite frankly don’t care what happens to Greece thereafter – I suspect a number of people share my views. Greece will try and remain in the Euro Zone (the alternative is ghastly), but I cannot see how the Euro Zone can continue to provide bail out funds, if Greece continues to ignore its commitments. However, the authorities will have to construct a firewall to avoid contagion effects spilling over to the other peripheral countries, in the event of a Greek exit – quite possible.
At some stage, the only practical solution for the Euro Zone is for Germany to accept higher inflation and, in addition, to support growth measures for the region, as opposed to austerity, which I really cant see working – indeed, austerity measures are being ignored by all, except Ireland. However, that’s a bit further away.
The UK will face recession next year. However, the BoE will introduce another QE programme in Feb/March, as inflation (mainly due to base effects) starts to decline significantly. Whilst sterling has held up well in 2011, I believe sterling will weaken to below US$1.50, against the US$, though should strengthen against the Euro.
Japan will face a serious economic and fiscal crisis in the coming year, which will support the US$ even more. I have never understood the reasons for the strong Yen. Will 2012 be the year of the Yen’s decline? It should and I will watch this potential trade particularly carefully. I am nearly as bearish on Japan, as I am on China. However, I need to do a lot more research on the country – one of my plays may well be to short the Nikkei and go long the S&P.
The SNB is coming under increasing pressure to devalue the Swissy – I believe there is a 75%+ chance that the peg will be raised to E1.30 from E1.20 currently. The Swiss Government will (unofficially) support the move. Personally, shorting the Swissy against the US$ seems a great trade to me – indeed, better than shorting the Euro against the US$.
Sovereign bond yields (US, UK and Germany) are likely to decline further, particularly in the 1stQ/half of the year, given the numerous crises that are likely to occur in the 1st half of the year. However, I expect yields to rise somewhat in the 2nd half and especially as we approach the year end, though there will not be a mass sell off.
I have been extremely negative on the financial sector (particularly in Europe) for quite some time now. However, I will look to buy the sector as the year progresses. I remain convinced that the provision of 3 year funding by the ECB is a game changer and the sector is cheap, particularly with the prospect of further significant monetary easing (certainly interest rate cuts and, in my humble opinion, QE) by the ECB.
I believe that after a difficult 1st Q (possibly 1st half), markets will react positively to monetary easing. Particularly if the ECB introduces conventional QE, as I suspect it will. Lower interest rates globally, with declining inflation and easing monetary policy should support markets. However, in the 1st Q/Half, I suspect being uber defensive will pay off. Corporate buy backs are likely to increase materially, which will support cashed up, good quality companies.
To pre-empt you Gold bugs, I reiterate – I do not follow and/or understand Gold. The only observation I have is that a strengthening US$ increases the downside risk on Gold. Furthermore, I certainly do not buy the argument that Gold is an insurance policy, particularly in an environment of declining inflation. However, others are far, far more clued up on Gold.
The biggest threats in 2012 include the Euro Zone (though I expect some sort of resolution next year), geo political risks, (of which there are many), a hard landing in China and significant problems in Japan. Overall, however, I expect that markets will recover from a difficult 1st Q/Half and could provide decent returns in the later part of the year.
I suspect that the 1st Q/half 2012 will be highly volatile, with potentially significant sell offs. Buy and hold, I believe, will be a dangerous strategy. Being long the VIX may well be appropriate and risk aversion will be the name of the game in the 1st Q/half. I certainly intend to be extremely defensive during the 1stQ/half and, on balance, short the markets.
However, thereafter … who knows?
All the very best for the New Year.
Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland. [/private]