UBS' Top Ten Surprises For 2012
Unlike other, more humorous instances, such as Byron Wein and his 10 endlessly entertaining year end forecasts, some banks take the smarter approach not of predicting what will happen, because only idiots think they have any clue what tomorrow may bring with any sense of certainty, especially under global central planning - a regime that is by definition irrational, but instead of stating what would be a surprise to a base case forecast. And with "surprise" now the new normal, it would be prudent to anticipate what to the status quo may represent as fat tails in the coming year. Especially since even UBS now mocks the Wall Street consensus, and the traditional upside biad: "Let’s face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." Which is why, with that advance mea culpa in hand, we bring to readers the Ten Surprises for 2012 from UBS' Larry Hatheway: "At the end of each year, in our final strategy note, the global asset allocation and global equity strategy teams join up to consider possible surprises for investors in the year ahead. Inside, we briefly describe ten such outcomes, and also provide a review of how last year’s surprise candidates fared." For those pressed for time, here is the full list: i) The consensus of bottom-up earnings estimates is right; ii) Financials outperform; iii) The euro rallies; iv) Oil prices fall below $70/barrel; v) Sovereign default outside the Eurozone; vi) Rising Treasury yields; vii) An Italian sovereign upgrade; viii) EU or EMU disintegration; ix) Fewer than five governments switch hands and, last but not least, x) Britain does Great at next summer’s Olympics. Let's dig in.
Ten for 2012
At the end of each year, in our final strategy note, the global asset allocation and global equity strategy teams join up to consider possible surprises for investors in the year ahead. In what follows, we briefly describe ten such outcomes, and also provide a review of how last year’s surprise candidates fared.
Our aim is not to second-guess our or our colleagues’ baseline scenarios. Rather, we are all too aware of what can happen to forecasts, particularly when shocks arrive or when consensus-like positioning evaporates. Of course, in these turbulent economic times, with elevated levels of sovereign stress and market volatility, the bar for qualifying as a genuine surprise keeps moving higher.
Ten surprises for 2012
Caveats aside, here are our ten surprise candidates for 2012:
1. The consensus is right (for once)
Let’s face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins.
So it qualifies as surprise in any year if the bottom-up consensus is close. Maybe 2012 will be the year they get it right.
Unsurprisingly, the collective wisdom of analysts anticipates another robust year of earnings growth in 2012, with global earnings expected to be up 11.7%. While this figure has moved lower in recent months, expectations remain overly optimistic. After all, global economic activity is slowing. Our economists forecast global GDP growth of just 2.7% in 2012. That figure is only slightly above levels normally associated with global recession and implies earnings growth in the low-to-mid single digits, at best.
Furthermore, the current bottom-up earnings estimate is generated on forecast revenue growth of just 4.2%, which implies significant margin expansion in the coming year to arrive at a double-digit earnings forecast. The assumption of margin expansion appears heroic. Margins have flattened or shrunk in the last two quarters. It is unusual to see a further widening of profit margins at this stage of the cycle, particularly from current levels.
So what needs to happen for the consensus of analysts to get it right?
For one, global GDP growth would have to re-accelerate to drive up revenue estimates. Operating leverage remains high across the corporate sector generally, so any increase in final demand above current forecasts could be magnified to the bottom-line. That would particularly be the case if companies remain cautious about hiring and capital expenditures. In that case, higher turnover would lift productivity and capacity utilization, factors which typically push profit margins higher.
Still, the conclusion is inescapable: Consensus estimates will only be right if everything goes right.
2. Financials outperform
Perhaps, after five years of underperformance, financials will outperform in 2012. Readers will be forgiven if that sounds both a bit far-fetched and self-serving.
After all, most of the conditions that have caused the sector to sharply underperform are still in place: Mounting regulatory hurdles (many of which are yet-to-be implemented), insufficient capitalization, deteriorating credit and funding conditions in Europe, fears of hard landings and property bubbles in China, weak turnover in capital markets, moribund primary businesses, a stagnant US housing market, etc.
And then there are the new challenges: Shrinking balance sheets and sovereign stress in Europe coupled with woeful policy responses. Looming ahead are possible further regulatory changes, reflecting popular discontent with banks, as manifest for example in the ‘occupy’ movements.
Maybe, therefore, we should just move on to surprise #3…
The hope, however, is that much of the bad news about banks is known and discounted. According to our global banks team, for example, expectations for the sector are low and costs are being slashed. As a result, any unexpected revenue pick up could lead to nice bottom-line surprises.
Furthermore, if some elements of the Dodd-Frank bill and Volcker rule could be eased, that would provide a further positive catalyst for the sector. Most important would be an early recapitalization of European banks, coupled with
more decisive action to stabilize the Eurozone sovereign credit crisis.
Of course, if sector performance depends on European policy makers getting it right, then arguably this surprise is the longest shot of them all.
3. The euro rallies
The resilience of the euro in 2011 was one of the bigger surprises given the immense pressures seen in European equity and bond markets. After starting the year around 1.33, the currency rallied above 1.48 in April and only recently has started to fall more sharply. Yet it remains within a whisper of its 2011 starting value at the time of writing.
In classic British understatement, all is not well in Europe. Europe’s policy makers have shockingly mis-diagnosed the patient, administering pro-cyclical fiscal austerity just as a full-blown credit crunch and deep recession get underway.
Meanwhile, the ECB had the temerity to hike rates earlier this year. It has belatedly undone its error, but still remains incapable of providing the monetary stimulus the Eurozone now clearly needs to offset fiscal austerity and tighter credit conditions. The ECB is more worried about moral than economic hazard.
Predictably, the Euro area economy is forecasted to contract -0.7% next year (with the annualized pace of decline around -1.7% in the first half of 2012).
In short, Germany and the ECB are conducting a majestic string quartet while Rome, Athens, Madrid, Lisbon and Dublin burn. And the sparks are beginning to fly in Paris as well.
In less prosaic terms, the euro is sliding in the currency markets. So it would be a big surprise if, contrary to all evidence and reason, the euro were to rally in 2012.
So why might it happen? Part of the answer is ‘the pain trade’. As our currency strategy team points out, the consensus is already short of the euro. In addition, strategists are falling over themselves to see who can forecast euro/dollar parity soonest. Hence, short-covering euro rallies are surely possible in 2012.
What else could help the single currency? Fundamentally, renewed US economic weakness and another round of Fed quantitative easing might do the trick. Even if unlikely, that scenario can’t be ruled out, particularly if financial contagion from Europe spreads across the Atlantic. A second source of (temporary) euro support could come from aggressive asset repatriation by European financial institutions striving to shore up their domestic liquidity buffers and capital positions in the event the Eurozone crisis intensifies.
Come to think of it, euro strength might not be all that far-fetched.
4. Oil prices drop below $70/barrel
Brent crude oil prices began this year at $95/bbl and proceeded to rally in almost uninterrupted fashion up to $123/bbl by the end of April, as ‘Arab spring’ unfolded. Since then Brent prices have trended gently lower but have remained well supported above $100/bbl, apart from a dip in early October.
The resilience of oil prices has been notable, particularly given the US ‘soft patch’ this summer, the advent of Eurozone recession in late 2011, and slowing growth across the emerging complex, including in China. Demand is likely to soften further and oil production may get a lift from some resumption of output in Libya. Accordingly, our oil team forecasts that the price of Brent crude will fall to $95/bbl by the end of 2012.
But the idea of oil prices falling even further from current levels (say 25%-30% or more) is difficult to envision given still-present tensions in the Middle East.
While a repeat of the protests and rebellion seen this year may be unlikely, uncertainty is likely to remain high, particularly as now regards Iran.
So an unexpected sharper fall in oil prices would require some reduction in regional tensions. The other way oil prices could drop more than we expect is via global recession. We are sceptical that could originate in China (we don’t fancy the hard landing scenario there) or from the US.
Yet again, it seems all trails lead to Europe.
5. Sovereign default…outside the Eurozone
We doubt anyone would be surprised by a Eurozone sovereign default in 2012. Greece, after all, is almost certain to default—only the form and precise timing remain in question. What would be a surprise is if an emerging economy defaulted first.
As we have noted elsewhere, sovereign balance sheets and fiscal sustainability metrics look pretty robust across the emerging complex. But a few risk cases stand out. The following chart shows credit default swap pricing for selected emerging countries. The highest probability of default, according to investors, exists in Pakistan, the Ukraine, Hungary and Croatia.
Among emerging countries, our strategy teams have highlighted that Hungary looks particularly worrisome, given its high sovereign debt-to-GDP ratio and weak growth prospects. Hungary also has the highest external public debt ratio in the emerging world. With significant foreign currency funding exposure Hungary is vulnerable to ‘sudden stops and reversals’ of capital flows, without the backstop of its central bank (which can only act as lender of last resort for local-currency bank financing). That situation is reminiscent of peripheral Eurozone countries.
Any unexpected sovereign default would boost risk premiums across equity and debt markets, probably leading to an underperformance of emerging versus developed markets. Safe-haven assets such as US Treasuries, German Bunds, the Swiss franc, and Japanese yen would perform best.
6. US 10-year Treasury yields break out
Despite large deficits, mounting debt levels and a downgrade, US Treasuries remain amongst the safest of all asset classes. Coupled with strong support from the Fed (in terms of quantitative easing), this has led to a period of dampened volatility for Treasury yields. Most investors expect more of the same in 2012.
What could prove them wrong?
The case for higher yields would be presented by a sustained improvement in US economic and financial conditions. That scenario would most likely be accompanied by a recovery in risk appetite and, ultimately, in shifting expectations for Fed policy normalisation. All of those factors would lead to a rise in yields.
The other path to higher yields would be a significant worsening in US sovereign credit quality. To be sure, investors continue to assign a very low default probability to US government debt. Alternatively, the appeal of US Treasuries could be eroded by common bond issuance in the Eurozone, creating the potential for a larger homogenous market for European government debt that could rival US government debt hegemony. That, however, seems a remote possibility.
In market terms, rising bond yields would obviously erode the value of Treasuries. A rise in US ten-year yields to, say, 4.5% next year would imply a negative -16% total return. Stocks would clearly outperform if the reason was stronger growth. A US sovereign crisis, on the other hand, would produce just the opposite result—a risk asset sell-off.
7. An Italian sovereign upgrade
Yes, you read that right—an Italian sovereign upgrade.
Here goes. The austerity package proposed by the Monti government has not yet persuaded the rating agencies’ to lift their outlook on Italian sovereign debt from ‘negative watch’. An Italian rating upgrade within a year appears highly unlikely—clearly it would be a big surprise to markets.
But it isn’t impossible. There have been two examples in the recent past where investment grade sovereign debt ratings have been upgraded within two years of the initiation of a negative outlook. The first comes from the Baltic region, namely Estonia and Latvia. They were among the most severely hit economies during the financial crisis, which resulted in Fitch announcing a negative outlook in April 2009. But both Estonia (July 2010) and Latvia (March 2011) were upgraded (to A and BBB, respectively) within two years of being put on negative watch.
The second example is Turkey. In March 2003 Turkish sovereign debt was put on negative outlook, but the Turkish government responded by slashing the budget deficit from about 15% of GDP in 2002 to below 5% three years later.
Fiscal tightening resulted in Fitch upgrading the debt first to B in September 2003 and again to B+ in February 2004, all within a one-year time frame.
So, back to Italy—can it make the grade? As our European economists have noted, the reform package in Italy is credible. We suspect that the criteria for an upgrade are three: 1) Final political approval of the austerity package (our economists expect this to happen before year-end); 2) Efficient implementation of the austerity package; and finally 3) Restoration of ‘normal’ liquidity conditions in Italian sovereign debt markets. The second and third factors arguably pose the biggest challenge to an upgrade. They are also interrelated.
For liquidity to return to the Italian bond market investors need to be convinced about implementation of austerity.
Investors would also have to be re-assured that Italy can avoid a severe and/or prolonged recession. For that, Italy needs help from Germany or the ECB.
So it seems Italy’s sovereign rating, like so much else these days, will be made in Germany.
8. An E(M)U exit
Over the past year, we’ve written extensively about the prospects for, and consequences of, Eurozone exit. The bottom line is that exit would be a dreadful mistake for the departing country, as well as for those remaining in the Euro area.
That doesn’t mean it couldn’t happen. One clear lesson from history is that when populism and nationalism are in ascendency, rationality is usually in decline.
And frustration with the mis-diagnosis of the Eurozone crisis—and hence the application of the wrong policy prescription (fiscal tightening without any offset)—could lead to a populist backlash and calls for exit.
But, equally, the imperative for a closer fiscal union (with proper transfers and common debt issuance) implies the need for a closer political union. That’s where matters also get tricky. Fiscal subordination and other forms of sovereignty transfer are unpopular in many parts of Europe. Look no further than to Cameron’s veto of the proposed changes to the EU treaty last week for evidence of ambivalence to ‘an ever closer European union’.
Nor is the UK as isolated as some might think. Within Germany there is open hostility to the idea of a ‘fiscal transfer union’. Nationalist and populist forms of discontent are already evident in Finland, the Netherlands and France.
Moreover, any discussion of ‘disintegration’ in the old world is not limited to the EU—it is also evident within countries. The rise of Scottish nationalism or the linguistic and cultural splits in Belgium offer examples of fault lines within nations.
To be sure, the political, legal and practical challenges of exit—whether from the Eurozone, the EU, or from national association are daunting. As a result, the probability of disintegration in Europe in the next twelve months remains very low.
But it has happened—Czechoslovakia and the former Yugoslavia provide the most recent examples of disintegration in Europe. And if Europe’s long history tells us anything, it is that political structures have a tendency not to last.
So watch this space. Even a rising probability of disintegration—particularly within the Eurozone—is likely to greatly unnerve investors and send them scurrying for the safest assets they can find.
9. Fewer than five governments switch hands
In 2012 a number of countries go to the polls. Incumbents are nervous, and rightly so as public opinion polls register mounting voter discontent. Already in 2011 turnover at the top has been in evidence, among others in Greece, Italy, Portugal, Belgium and Spain (not to mention in the Arab world, albeit under different circumstances).
So it would not come as surprise to see many fresh faces in office at the end of 2012. Given the number of elections (and other ways political change could happen), the surprise would be if fewer than five heads of state are shown the door in 2012.
Political change is already determined by process or law in China, Mexico and Russia—so we won’t count those in our baseline of five. Otherwise, elections are scheduled next year in Taiwan, Finland, France, South Korea, Switzerland, India, The Ukraine, the US, and Venezuela. In addition, coalition governments are feeling strains in countries where elections are not otherwise scheduled for 2012—among them, Germany and the UK.
10. Britain does Great
The summer Olympic Games will be held in London next year and provide a bevy of opportunities for surprise. Rather than think about individual events and the historical dominance of certain nations in certain disciplines, we choose to focus on the home nation’s prospects. The following chart shows that until the last Olympics in 2008, Great Britain consistently achieved a number six rank in the summer Olympics. In 2008, ‘Team GB’ leapfrogged to fourth place, narrowly missing out on a top-three result.
Next year, a ‘team bronze’ is within reach. Discouraged by Eurozone political ineptitude, we have recently turned our research focus to the academic literature of sports and have built a model to forecast the country medal count next summer.
One well-known tenet of ‘Olympic modeling’ is accounting for host nation advantage. Host nations usually manage to boost their medal haul relative to previous Olympics (and also suffer ‘hangover’ in subsequent games). Whether the host advantage resides in ‘home cooking’ or more favorable treatment by judges, officials and referees we can’t tell, but the tendency for the hosts to do well is clear.
So what do our models suggest? The table below is our prediction of the medal results at the London Olympics, ranked by number of gold medals (rather than total medals).
In short, we wouldn’t be surprised by a top-three result for Great Britain. The real surprise would be for the Brits to finish ahead of either the Americans or the Chinese. Or to finish below the Australians—heaven forbid!