The year of terror is over and 2012 looks much more hopeful than could have been predicted just a short few weeks ago. Lost by the media focus on Christmas, the ECB, comforted by the European Summit’s fiscal compact which relieved it of its concerns about debt without discipline, finally intervened with a substantial dose of money printing, aka quantitative easing. Abracadabra and nearly a half a trillion Euros were created out of thin air and released across a European banking system tottering on the edge of collapse as overnight ECB deposits hit the roof and banks stopped having any faith in each other. The ultra-soft ECB loans at 1% pa for three years (contrasting sharply to Ireland's 6% on Anglo’s promissory notes), provide banks an irresistible margin to recycle much of the cash into European bonds at yields many notches above borrowing costs.
Is it enough? No is the short answer. The Euro crisis is far from resolved, especially Greece’s continuing toxicity but, as Europe finally finds some direction, the risk of an imminent banking system collapse has gone from DEFCON 1 ( nuclear war imminent) to DEFCON 3 (advanced readiness). As the crisis significantly escalated in the second half of last year following a peak in equity markets in May from their deep trough two years earlier, we issued a special alert to which many of our clients responded, reducing exposure in unprotected funds in favour of more defensive ones.
Although we enter 2012 with some cautious optimism, risk levels are still quite elevated and so, except for my own clients with higher risk appetites, I’m recommending everyone else to maintain defensive positions in funds, many of which give limited exposure to the upside, if, as is quite possible, 2012 results in strong returns on equity and commodity markets, excluding Europe due to the recessionary headwind facing it.
Elsewhere the USA economy is showing early but tentative signs in an election year that its private sector is exceeding the stimulus premium, in other words picking up from the effect of fading stimulus and driving under its own steam. Job growth is the indicator and its strong monthly pick up, is combining with better news from retail sales to hint towards a sustained recovery. That explains why US equity markets have held up well against the misery out of Europe. But US debt, which has exceeded US GDP for the first time since 1944, is unsustainable. Meanwhile fears of overheating and a burst in the Asian region has reduced as fiscal tightening by policymakers, especially the Chinese, appears to be doing the trick although swollen asset values, most particularly in property remain a concern.
EUROPEAN EMPIRE BUILDING AMID CRISIS
Recent downgrades of European sovereign debt including France losing its AAA status, as the USA and Japan has done, shouldn't surprise and has been well flagged. What markets are telling Governments is that they must engage in the reforms necessary to make their economies more competitive and thin out the cost of the State as a percentage of GDP over time, so that growth can return. It's a difficult message to absorb especially for entitlement cultures like the French which, in my view, may yet prove to be the most problematic economy in Europe.
Until the months roll by we simply can't tell how shallow or deep the European recession will be. Political wrangling among the big beasts on the European stage in the latter stages of last year, spikes in Italian and Spanish debt leading to fears of a too-big-to-fail event and, a continuation of the basket case that is Greece, inevitably hit consumer confidence. Better helming by policymakers, at least now rowing in the same direction towards deeper fiscal union, should mean that the recession is short but even if sluggish growth returns, austerity and structural reforms are unavoidable.
The conventional route out of a sovereign debt crisis is a combination of currency devaluation and large scale monetary easing by lowering interest rates and printing money, to trigger the economic lifting power to jump out of the hole with higher growth.
Europe, instead appears to be choosing the most difficult path out, little growth, no devaluation (although the Euro is weakening), structural reforms to improve competitiveness and austerity, while the ECB transforms into a repository for bad loans. The result, unquestionably is a slow recovery from recession and many years of rebuilding and reconstruction of Europe, pockmarked by political impasses as austerity reaps it's bitter historical harvest once again - strikes, riots and social unrest that will ultimately test the heart of the empire, its undemocratic, non-transparent and shadowy Brussels elite.
USA MIRED IN DEBT AND UNCERTAIN LEADERSHIP
As ever the US economy is defying sceptics with many indicators pointing up, manufacturing, consumer spending and reductions in loan default rates as US consumers repair balance sheets and corporates build up vast war chests of cash, estimated to exceed $2 trillion. Since the commencement of the crisis, the domestic US economy, despite very high consumer debt levels has heavily influenced by the spending behaviour of its wealthiest where the top 10% account for nearly 40% of spending. Unlike lower income and younger consumers this sector isn't debt burdened and far more influenced by the feel good factor of recovering equity markets.
But the impasse between the President and the Republican- dominated congress, manifesting itself in the failure of the Super Committee to agree a sustainable debt reduction programme, means that US debt continues to barrel in the wrong direction.
The US is vulnerable and far too reliant on its status as the world reserve currency as outsiders use the dollar as a store of value by buying US debt. This is the weak spot. A heave against the dollar is already underway as Governments like China opt for bi-lateral deals with resource rich countries rather than trade through the greenback and tentative discussions, are no longer the musings of academia and are underway between players on what a new world reserve currency might look like. Time as the reserve currency is not unlimited as the Spanish, Dutch, French and British can testify but, with the Euro in crisis, any short disruption to US plans looks unlikely especially if the next US administration robustly tackles the debt issue, and popular support rows in behind it.
ASIA POWERS AHEAD
Excluding Japan, the Asian region did well last year although this was not reflected in equity markets which were overpriced as fiscal tightening needed to cool down overheating economies and inflation, began to bite. The retreat of inflation and the continued surge in organic growth which should offset lower export revenues to recession-hit Europe, means that Asia, the bellwether of the newly industrialised world, remains the best growth story, built, as it is, on strong fundamental foundations and playing catch up with the developed world as its vast populations benefit from rising middle class wealth. Although growth is likely to be lower, Asia isn't without its own risks particularly the on-going risk of a credit-fuelled asset bubble like Chinese property, a weakness that will need careful handling by Beijing.
The Irish economy cannot simply rely on job growth from exports and improved competitiveness. Without resurgence in the domestic economy, unemployment will remain at very high levels, straining public finances already puffing under the weight of rising debt/GDP. While the media and public focus has been on gaining a reduction in our overall borrowing costs, that is not the main challenge. Indeed a restructuring of our debt looks inevitable, if anything because Europe must have a winner in its internal devaluation policy to encourage the others.
The domestic economy is moribund with no chance of recovery without policy changes. Firstly a modern and human insolvency process must start working on the 200,000 inactive and insolvent Irish consumers through customised and phased workouts of excessive debt burdens. Secondly Government policy must shift much more towards cuts and desist from threatening consumers with higher taxes.
As tax revenues decline, which I think is inevitable; politicians will be forced down the road that must be taken, shrinking the State as percentage of economy, lightening the load on the prosperity generating other half. Meanwhile Irish property values and, with it the inverted wealth effect that comes from the devastation of middle Ireland balance sheets, will remain a huge drag on morale. Credit remains restricted, policy flips are destroying property as a leveraged investment asset, and wrong-headed attempts by the Dept of Finance to cocoon NAMA from rent adjustments despite the huge inventory overhang, all point to a prolong winter for Irish property. So despite falling prices, Irish rental yields are not yet at a point necessary to compensate for the extra costs and risks involved in becoming a peripheral player in a market macro-managed by the State to protect its own assets.
Saving for increased productivity created by major technological breakthroughs, the developed world is on a low growth trajectory - despite structural reforms and austerity. Most of the fundamental economic growth on the planet looks likely to take place in newly industrialised economies over the decade ahead. The world is integrating at a rate of knots and unlikely to be blown off course by fumbling, politically- inspired attempts to raise trade barriers in a futile attempt to ring fence uncompetitive economies. That means that global top brands, major multinationals, that enjoy high revenue streams from faster developing regions, remain a sound investment concept.
In the short term Europe is to remain a problem as growth struggles against the headwinds of austerity and poor consumer morale while policymakers continue to scare us occasionally by playing chicken with markets. Ironically Europe's crisis is diverting attention from the US where the financial crisis that started with excessive leverage over a decade ago, must end. That end phase has yet to come and, with it, test US resolve and its capacity to hold on to the dollar as the world reserve currency.
I remain convinced that resource scarcity combined with quantitative easing will inevitably lead to higher inflation. That’s I continue to favour assets that are aligned to higher inflationary forces, including Global Inflation-Linked Government Bonds protected with a Euro hedge and benefitting not just from sovereign guarantees but likely Euro weakness until policy implementation catches up with intentions. In this environment and despite the sell off towards the back end of 2011 and continued short term vulnerability to Central Banks selling off reserves, gold is likely to trade higher in 2013 than today.
The historical premium paid for technology funds has substantially changed and is more in keeping with normal stock market valuations, which continue to remain relatively cheap compared to boom periods. So 2012, despite the continuing risks from Europe and rising geopolitical risks from the Iranian nuclear programme, may yet see a strong year for many equity markets, with Europe as the laggard. Commodities, led by oil, are likely to experience a strong year despite the weakness created by Europe and slightly lower growth in developing regions
So for younger, long horizon investors, the worst may be over and 2012 could contrast sharply with 2011 as equity markets price in stronger economic growth and corporate earnings into the future. But for others whose objectives are to maintain the value of their balance sheets in real money terms, the most appropriate tactics are to remain sceptical, sitting in largely defensive investments, biased to higher inflation into the future, with some scope to share in higher economic growth.
Despite the reduction in risk, the banking system still remains on life support from the ECB and vulnerable to a breakdown in European policy cohesion. Cash deposits are likely to continue to face negative real returns for some time to come despite a modest fall in inflation.
As ever with forecasts, you can only grapple to make sense of the known. Each forecast remains at risk to completely unexpected events of national, regional or global significance, so called black swans. These can be positive, such as technological leaps forward or negative, like a catastrophic earthquake. For the time being, except for those chasing high growth over the long term and happy to play the long game which involves reading downturns as buying opportunities, I recommend continued caution, but caution with guarded optimism especially for equities.
After the shock Lehmann collapse in Sept 2008 most investors were best advised to hold position, riding the up cycle from the deepest part of the trough some six months later. That proved the correct tactic as markets rebounded strongly to the summer of 2011, since which and, largely due to the elevated risks from the Euro crisis, switching to more defensive funds made better sense until the extreme risk period past. Staying defensive still looks like the right tactic until Europe follows up its new policy direction with the necessary actions on the ground across its nation states, actions that convince markets that the crisis is coming to an end. In the meantime real growth in asset values remains outside of Europe.