Jim Reid and his team from Deutsche have produced another magnificent compendium of information and prognostication in their 2012 Credit Outlook and while their up-in-quality preference (non-financial) may not be earth-shattering strategically, their timing view is of note. Instead of viewing the looming refi-ganza among European sovereigns and financials in H1 2012 as a reason for doom and gloom, they see it as the necessary evil to drive the ECB into the markets in size only for the latter half of the year to disappoint significantly as the reality of the underlying problems rear their ugly head once more. The down-then-up-then-worse-down perspective on markets for next year hardly sounds optimistic but it is the following six scenarios away from European woes that keep them up at night. From the positivity of a US housing rebound or Election year cycle to much more extreme downside risks such as geo-political concerns and non-European sovereign risks, their views on China, QE-evolution and Inflation concerns are noteworthy.
Before the six scenarios though, one of the most interesting longer-term charts we have seen recently for some context of where European Sovereign Yields have been:
Obviously there is plenty of room for decompression still and that is Deutsche's view of H2 2012 market reactions to another risk flare - but that's tale well told recently.
Six Curve Balls for 2012
1->Disappointing China/EM Growth And Ongoing Geo-political Risks
There does seem to be a complacency that EM growth will continue to be the global engine and help provide the developed world some kind of safety net. What if China does see a hard landing? The imbalances are becoming more intense and with it the risks. Our GEM strategist John-Paul Smith has concerns over China for three main reasons. 1) Inflation is likely to remain stubbornly high; 2) The banking sector is unlikely to be able to help policy easing given the increasing worries over previous over lending, asset quality and subsequent NPLs; and 3) The recent data on deposits and capital flows may be an indication of incipient flight out of fiat money in China as depositors begin to realise the asset quality problems the banks have. JP’s base case is in line with the house view that China will be able to fine tune the economy but it is arguably going to be much more difficult than it has been in the past and as a minimum the country is unlikely to be the driving force for global growth it once was. For more on the challenges for GEMs please see ‚GEM to underperform again in 2012 (6 December 2012) – John-Paul Smith and Mehmet Beceren.
A similar view is held by our Asian equity Strategist Ajay Kapur. He suggests the following.
"We are increasingly concerned by the combination of high and increasing leverage in China, coupled with an impending peak in China’s working-age population ratio and its level, combined with a rapid ascent in property prices there. Our preliminary work shows this has been a potentially dangerous combination in the past 40 years when and where it has occurred, highly likely followed by a credit and property bust, either brief or prolonged.
Timing this is tough, and we are familiar with the "this time is different" list of arguments in China – low mortgage penetration, urbanization, it is a localized problem, etc. It always is different – that is what we heard in Japan, Korea, Thailand, the United States, Spain, Ireland, etc., when confronted with similar combinations of elevated leverage, property price escalation and peaking working-age population ratios. However, it wasn’t that different in the eventual outcome of suffering large capital losses."
2->Japan/US/UK Sovereign Risk?
Many believe that Japan could well see a funding crisis. Given its huge debt level it seems unrealistic to think that longer dated bond holders will ever be paid back in full in inflation adjusted terms. As the population ages and savings decrease, the domestic appetite for JGBs will diminish. There is no sign that this will happen in 2012 but with all eyes on Europe it’s important to keep tabs on this situation.
With regards to the US, their comparative "safe haven" status has allowed them to be one of the few developed markets without the need for immediate sizeable austerity. The budget problems of August 2011 will start to put some breaks on the debt accumulation but more through politics than being forced to do it by the market. At what point does the market conclude that US longer dated bond holders are unlikely to be paid back in full in inflation adjusted terms. Again this is unlikely to be 2012’s problem but we mustn’t ignore the considerable fiscal issues the US faces.
For the UK, austerity and an aggressive BoE seem to have helped turn the Gilt market into a safe haven in 2011. However, these are unusual times and the BoE will likely own somewhere between a quarter and a third of the Gilt market as 2012 progresses (around 24% when the latest round of QE ends at the start of 2012 with more QE likely). Will the market take fright at this level of monetization at some point and will the very weak growth seen since austerity was implemented start to impact the UK’s sovereign worthiness in markets?
Maybe the answer to all of the above is that Japan, the US and the UK will benefit while Europe struggles. However, longer-term they all face enormous funding issues.
3->Inflation To Come Roaring Back?
We don’t think this is imminent but we do think that if we continue to print money (which we probably will across the globe in 2012) the collapse of the Fiat currency system that has prevailed since the Gold Standard was abandoned in 1971 could eventually occur. So the path to future fiat currency destruction could be further cemented in 2012.
Figure 24 from our "Roadmap to the Grey Age" document reminds us that inflation across the globe behaved differently from the Twentieth century onwards. Prior to the twentieth century creating money was difficult to do consistently when most currencies were backed by precious metals. The ease of creating money in the Twentieth century dramatically changed during periods when the Gold Standard was halted (during wars and after the Depression) or post its collapse in 1971. Indeed today we live in a world of total fiat currencies where printing money can occur at the press of a button. Such temptation is going to be difficult to resist given the problems we face. Fiat currencies have lasted as long as they have probably due to Globalisation subduing prices thus offsetting substantial money creation over the last 40 years. We’re not sure such a system can last forever and although 2012 will not be the denuement, this is a key story to think about going forward.
4->Does QE Change?
So far money printing has all been about buying bonds. However there has been doubt about whether this actually helps out the underlying economy. Could the debate change as the year progresses? Will central banks consider buying other assets (equities, real estate) or even policies more in-line with Bernanke’s famous ‘helicopter drop’ analogy? For those that don’t think QE has any impact on long-term inflation because it doesn’t impact wages, maybe a radical solution would be to print money and directly hand the money over to consumers?
This might sound farfetched today but we’ve learnt in this crisis that things that sounded outlandish, say 6 months before they happened, often became mainstream discussion points or actual official policy.
US housing has now been in decline for nearly 6 years and although it still looks like we have some way to go before we work through the inventory problem it does seem that value has returned to certain areas. While we think it’s too early to sound the all clear, it’s possible we are wrong and any evidence of this is likely to excite the market that the US is finally pulling out of its housing led crisis. So watch US housing stats all year.
6->US Election Years
The often touted perception is that US election years are good for risk assets. Given that 2012 is such a year then we will likely see some talk about the positive ramifications for risk. However, there is an argument for saying that this relationship has changed over the last few decades and also may be deeply impacted in the current environment by an administration that has little ability to provide last minute fiscal giveaways.
Indeed Figure 25 looks at nominal returns by year of the S&P 500 since the data starts in 1824, since 1900 and finally from the first full post WWII cycle starting in 1948. In the early decades of this relationship it seemed like election year and the year prior to this saw notably higher returns than the two middle years of the administration. However it does seem that since WWII the year before the election has consistently been the year to see outsized gains.
Indeed between 1951 and 2003 (inclusive), 13 of the 14 pre-election years saw double digit S&P 500 gains. 1984 (+5.2%) was the only exception but was still positive. 2007's +5.5% and 2011's +0.85% (to date) returns seem to be telling us that things are again changing post the credit crisis. For the record the last election year in 2008 saw a 37% decline in the S&P 500.
We think that this changing trend is because we hit the end of a debt super-cycle in 2007 - that arguably started post WWII. In this new era, the ability of Governments to manipulate spending in accordance with the election cycle has been seriously impacted. So while we always think such analysis is fascinating and relevant we think we are in a period where politicians have their hands tied behind their backs, more than at any point in several generations, thus nullifying the election cycle impact on returns.
The other thing to watch is how the fiscal debate progresses as the election nears. This could have a substantial growth and sovereign credit quality impact as 2013 nears.
Much as they say it, these may not all be 2012 'events', but they are certain to all be discussed ad nauseum over the coming year for better or for worse.