From Maurice Pomery of Strategic Alpha
2012: HOPE AND EXPECTATIONS
Whilst I realise that this year of 2011 has been a difficult one for many, it appears that a lot of strategists are now seeing a lot of what we forecast for the year materialise, albeit belatedly. Thus they write of impending doom for 2012 and this wave of pessimism takes a lot of strength to get through. Regular readers of my daily will however be aware that we see it as our task to start every year with hope and expectations that our elected (and in parts of Europe, non-elected) leaders will deliver us from impending peril (mostly being responsible for putting us in it in the first place) and set us on the road to recovery. What I aim to do is to try as hard as I can to maintain some of that hope and I fully expect our leaders to try to deliver but we must look at the risks to these thoughts as we are investors after all. Running a portfolio through this turbulent forthcoming year will be difficult and flexibility and manoeuvrability are key. We must be aware, as we invest in markets, that depth of liquidity is crucial, so that we can get out as easily as we can get in, right or wrong quickly. A lot of the risks are now known and manifest themselves in the guise of the EU sovereign and banking issues but the risks run a lot deeper than that and the common belief that the world’s woes are cured if the ECB steps up and prints money are misplaced.
However I do not want to be just another doom and gloom guy without very good reason and one of my many fears is that our central bankers are now trying an experiment (QE) that is untested or at least is questionable as to whether it can work in the modern globalised environment and who knows what the side effects will be? In the developed world we have some central banks (US FED and UK’s BoE) that endorse the programme whilst Europe and specifically the Germans do not (as they have seen and lived through the consequences), for good reason. So rather than looking at country by country specifics and economics, I want to deal with the list of risks we know are apparent this year and comment on the ones we know and suggest a few we do not. My hope is that none or very few will occur but driving on this freeway we need advanced warnings of bad weather ahead. My greatest hope is that we shall learn from these lessons and rebuild a stronger and more efficient system as in my view the system is close to breaking.
Capitalism in its truest form requires failure to be replaced by a stronger system; that is how it works and has since time immemorial. Without the allowance of failure we end up with a system that is dysfunctional and I think we may be close to realising this but we need the strength of leadership to allow it to break and rebuild, no matter how painful. Sometimes safeguarding the status quo or a broken engine comes back to bite you even harder in the future. Not since the Second World War have we required such strong political leadership but politics can get in the way and you will see that this is one of the biggest risks to recovery out there right across the developed world.
I cannot think of any bigger subject to start this piece with than that of growth. In fact it is central to many other risks out there as I will explain as we go through this. Of course we still have quite a disconnect between growth expectations in the developed world from that of the emerging Nations and exporters but in this global village in which we now live, it will affect all eventually.
In the developed world we are trying, rather poorly, to deal with a massive debt crisis and the medicine prescribed is one of severe austerity measures to cut spending. Actually the idea of cutting the deficits is a bit of a misnomer as what we will see for many years is just a slowing of the speed of the rise. The problem is we have sovereign, banking and household debt and austerity measures always come with higher unemployment as cuts to public sector spending are par for the course because that is all the government has. Some politicians believed the private sector could take up the slack but this is ridiculous as the very austerity measures help create the slowdown in growth and loss of confidence; they always do. This is an effect that is impossible for politicians to gloss over and they need to be honest about what is needed to get us back on a sound, sustainable footing. Hardship and recession are just about nailed on to 2012 in my view as we need to change the way we live and most will be fighting and kicking against that all the way. It usually takes extremes to achieve this but we have seen it before, unfortunately during and after wars. Debt is a curse in our society and it has to be eradicated. The problem is the cost is lower growth, deep recessions and long-term high unemployment. It is tough for a political leader to ride on that ticket.
So if we look at the other risks out there, they all come with associated risk to growth. We have austerity measures which I have mentioned, we have deleveraging at sovereign, banking and household level as debt is shed. We have the banking crisis in Europe with its interlinked tentacles to the world’s banks, some of which may fail. We have depressed housing markets in the developed world and rapidly rising real unemployment levels as the banks refuse to lend and demand is weak. We have small and medium sized businesses (essential to any form of sustainable growth) afraid to take risks and expand or employ as the costs and risks are too high. We have almost record lows for consumer confidence in many parts of the developed world and youth unemployment across Europe and indeed the US will see many disaffected hit the streets with civil unrest commonplace. ALL of this is bad for growth and the politicians seem rather distracted with their own survival. But it gets worse as benefits must surely be cut too and in the US they already have about 46mln on food stamps and the real unemployment rate is closer to 14% than 8.6% in my view. Not only have we been piling up the debt in the developed world, we have been offering promises of benefits to a wider portion of the electorate in return for votes. Every new government comes to power on the promise of spending more. This has got to stop. Governments don’t earn any money; they can only borrow it or tax.
In the UK recently the public sector was bigger than the private sector which is total nuts! The public sector creates no wealth, it is just a cost. Did no one realise this? Give me strength but this is a clear indication of how wrong the system is. Are governments ever going to be strong enough to stop this? Creating in an environment where not working is rewarded or “cost effective” is wrong and creates a worrying precedent that is hard to break. The US, like other nations will find it very difficult to reverse long-term unemployment (as they are now experiencing) whilst the benefit system is as it is. That, along with Medicare or the likes of the National Health system in the UK are bottomless pits, as we have not seen a government yet willing to even mention cutting funding to what is now clearly a bottomless pit for tax receipts. Politicians want power and few will last if they make a stand. I am afraid it may take a massive crisis to allow us to force change.
Again some apologies to my regular subscribers for pushing this subject again but it needs to be covered as it could be the greatest threat to countries, politicians and the global economy out there. As I have mentioned, there is deleveraging at country, banking and household levels, as all are forced to shed debt, whether due to regulation, ratings or simply maxing out on credit. Debt reduction is clearly being tackled but there is no consensus on the most effective way of doing so. The UK for instance has embarked on a mission to try and reduce the rise of the deficit with some tough spending cuts and austerity measures. This has placated the rating agencies for now but is hitting growth. Europe has a massive issue with debt and in some countries they seem to have even abandoned democracy in an effort to drive down debt. In the US though, the fight has not even really started and probably won’t start in earnest until after the election at the end of 2012. This is a nightmare as their debt will continue to rise fast, leaving the medicine almost too strong to take. I believe the US may lose its Aaa rating at other agencies this coming year!
Banks are being forced to shed debt as regulations force a rebuild of capital and balance sheets. This may yet get put back for a while as many suggest that the deadline for June simply cannot be met. There may be some sort of compromise from the regulators but it would be wrong morally to do so. We will therefore see a race to strip and sell assets, banks will hold onto cash at all costs and thus the credit drought will continue. We are in the midst of a joint cycle slowdown in both the credit cycle and the business cycle and we should all be worried about that. Banks in Europe are taking as much as they can from the ECB (LTRO) and then depositing it straight back to them. They have no intention of lending; not even to other banks! This they do with the full knowledge that it actually costs them money to do so! They are not even taking the cheap money and buying Italian bonds as many suspected they would. Talk about afraid. The banks are a massive threat to all and the system is certainly cracked and the interconnectivity consequences are scary. Why would banks borrow at 1% and deposit at 0.25% unless they had to? If alarm bells weren’t ringing about the risks here then they should be. I believe 2012 will either see a massive rescue of a major bank (probably a European but not necessarily) or the failure of one. To my mind the system probably needs it, painful as it will be. At some point very soon the sovereigns, banks and households will be forced to change the habits of debt and overspending. THAT will kill growth for a long time.
It is likely to be the banks that force the solution in a strange way as a bank failure would create the environment for radical change. Change like dramatically privatising corporations and slashing costs in the public sector to balance the books. Getting the ECB step up and change its mandate or print itself out of the crisis. The problem here of course is well documented and it is the Germans attitude to this for good reason as we suggested earlier. The problem here and indeed for the Fed and the BoE is whether this is sound economics. As I said at the start, this QE vehicle is still an experiment and the Germans and a few others (me included) are concerned that rampant inflation may be the bye-product at some point.
This is where I see the problem hiding for the US at some point and possibly the UK as well. The issue is that all that has been done with QE is to fund the banks as it is clear they have taken that money and hoarded it. I see little evidence in the data that it is helping unemployment or indeed housing for that matter. QE may have initially stopped the depression but possibly has only delayed it. It also appears that both King and Bernanke at some point soon will give them billions more. The problem comes when that money is actually released into the system and finds its way into the bloodstream of the economy. It will immediately lose its value and stores of value will be sort as faith in the Dollar or paper money in general, disappears. The central bankers that believe in the Keynesian policy are building a dam that I am afraid will burst as inflation drowns us in a sea of worthless money. That is why the Germans fear it so much. Quite what the alternatives are (such as backing money with gold again) is unclear but money backed by debt in this age seems rather ridiculous and dangerous in the extreme. My fear is that the ECB will be press-ganged into printing and who knows where Bernanke and King will stop, especially if we get the head-fake I think we will in the form of deflation first. This will distract them all but from the embers of deflation comes the threat that is hyper-inflation and this is not being too dramatic. Many see the US recovering slightly as sell-side data is bolstered by inventory rebuild but things are not sustainable.
However on the subject of QE or printing money, what does concern me is that Japan is not in more focus. Things in Japan have seemingly been so bad for so long that no one takes much notice. They should as they are the third largest economy in the world. Unfortunately Japan's marketable public debt is already the largest in the world at $11.2 trillion compared to America's $10 trillion. As the brilliant Zero Hedge guys pointed out; if you look at the upcoming issuance, Japan is about to issue more than it receives in tax receipts meaning that new bond sales will exceed tax revenue for a fourth year! How can this go on? They are literally flooding the system with money which is a massive concern as the locals take up most of it. It is fast becoming worthless at home. Japan is involved in a giant Ponzi scheme that when realised will see yields soar. Their debt is simply enormous and they keep printing to meet budgets. Remember that Italy went from stable to garbage when interest rates went from 5 to 6%. Japan will fall apart if rates go to 2%. 2012 may well be a tough year for Japan as time is running out. WHAT IF QE DOESN’T WORK OVER TIME? On top of the new and re-financing needs, the Japanese government estimated that the economy will shrink 0.1% this fiscal year citing supply-chain disruptions from the earthquake and tsunami disaster in March, the strengthening of the yen and the European debt crisis. So what happens if Japan gets downgraded? S&P have threatened as much. Things could get a lot worse in Japan if that happens.
Of course there is another danger with capitalism in its truest form. Not only do you need failure but you need free markets and again I fear the heavy hand of central planning will try and manipulate markets with bans, regulation and all sorts as they try and blame the ruthless speculator for all their own errors. My fear is the Fed is still geared to the needs of the banks than the greater good of the economy and that politics, especially with gridlock in Washington for another year, will fail to grasp the nettle and act in a timely manner.
"The only thing we have to fear is fear itself - nameless, unreasoning, unjustified, terror which paralyzes needed efforts to convert retreat into advance." FDR - First Inaugural Address, March 4, 1933. We need to put this statement, as great as it was insightful, into the context of the times as it may be something we will be facing soon in our times as pessimism over the future grows. FDR was actually looking back and trying to pick up the pieces and drive citizens out of their gloomy outlooks as he knew that in crisis, consumer confidence matters. This is something I have been banging on about for a while now. One thing the politicians are trying to combat is a loss of faith or fear itself. "One of the things which danger does to you after a time is -, well, to kill emotion. I don't think I shall ever feel anything again except fear. None of us can hate anymore - or love."- Graham Greene - The Confidential Agent (1939). Again look at the date! I am trying not to be too gloomy but at a point the populous become aware and the truth is exposed and this is generally brought about by continuously rising unemployment or conflict. Depression or war. How do politicians continue to get consumers and indeed businesses to take risks and expand? Reduce the tax burden is one way but the risks are believed to be lower tax revenues when they are needed most. This is the dilemma facing the hamstrung coalition in the UK. They want austerity measures and growth. That does not compute. What it needs is a political leap of faith that suggests that in the long-term tax receipts will increase if they cut corporate tax and NI costs to small and medium sized businesses in order to stimulate growth and employment. To remove the fear they need to offer hope.
Risk is being frowned upon and those responsible for where we are point the finger at the markets. This is a big mistake as if you take away speculators you take away free, deep liquidity markets. Risk is good in other words. But where is the political will to make a true difference, rather than trying for just another session of power. Where are the politicians who believe in the best for their country and its citizens? Only those who dare to fail greatly can ever achieve greatly. ~Robert F. Kennedy.
In my mind it is time to offer free enterprise its greatest opportunity as it is here where the real recovery resides, not in the future of the next resident in the White House as “times they are a changing”. So here is the quote that highlights this best for our times now; Politics, it seems to me, for years, or all too long, has been concerned with right or left instead of right or wrong. ~Richard Armour. Politicians need to change as much as the banks do as they are part of the risk out there. They are certainly not helping.
Obviously I am extremely concerned with the risks out there and the part that our leaders play in all this in an effort to stay in power but the central banks are now so stressed, they are taking unknown risks as well. Something is obviously very wrong and the system is close to breakdown. It is fixable but will take a lot of political will and strength or possibly a coordinated move form a forum like the G20. The other problem I have is that to get action it seems the crisis needs to deepen further which is a major concern as most nations are still looking inward and are in all senses of the word, protecting their own. This is clear in the EU zone and is also showing up on the global stage. I fear that to get real change, we may have to see another major crisis, either banking, Sovereign or geo-political, to get anything real in place.
I am not convinced that QE works and it is evident that the impact is waning. Quite what the side effects are is unclear but looking at the maths, I suggest we are building an inherent risk of hyper-inflation in coming years as we continue to kick the debt can down the road. This problem may not be faced by current government but at some point it will. The longer the delay the greater the risk and collateral damage. Politicians come and go and for good reason. “Politicians and diapers should be changed frequently and all for the same reason”. ~José Maria de Eça de Queiroz. However whilst in power, every now and again throughout history, some are forced to take up the challenge for the country over and above himself or the political goal. This time is now so choose your next leaders wisely and reject coalitions that offer little more than compromise.
The EU is still a massive risk to the global economy but so is political inaction, over- regulated or manipulated markets, high unemployment and geo-political shifts. QE is a concern as central banks abandon inflation targeting and indeed growth to maintain ratings. The EU is still throwing liquidity at a solvency crisis at both sovereign and banking level. EU banks not only have a cash problem, more specifically, as ECB President Mario Draghi says : "hoarding at the ECB signals that the problem afflicting the Euro-zone is not so much about the amount of liquidity but that this liquidity is not circulating around the region's banks". I am not surprised as they all know that each has a similar or worse problem sitting in the vaults.
In the first throes of the new deflationary cycle the Dollar will do well, as the fight intensifies and the US uses the Dollar as a monetary tool and prints more Dollars, it will fall precipitously. Correlations will break this year and many of the “relative value” trades will implode. Gold will break away from being pressured by a strong Dollar as the hunt for alternatives to Fiat currency explode. The likes of the AUD will fall steeply as the global growth story rolls over as we have suggested for a long time. But it is China that holds the key. Hard or soft landing is the question. Can they really have a soft landing if the developed world implodes? No chance.