2013: Fingers of Instability

Our Man recently looked at some of the things that could help the economy and markets in the upcoming year, now for some of the things that offer more concerning thoughts. 

- European debt problems (and recession?) 

While Draghi’s efforts have enabled Europe’s weaker countries to have continued access to the debt markets, they haven’t prevented a number of European companies from having tepid growth or falling back into recession.  The risk in Europe continues to be further political breakdown driven by the weak growth (or negative growth), especially if it persists in the stronger European core.  During 2013, some things to watch will be the elections in a number of countries (especially whether we see an anti-reform government in Italy, and what happens in Germany) and whether there will further unrest in the austerity countries (especially Spain and Greece). 

- China (and the rest of the BRICs)  

While China appears not to be a concern in the short-term, after growth picked up in Q4, there continue to remain question marks over the veracity of the data.  The other major concern over China’s growth is the aggressive government-sponsored/encouraged expansion of credit, and whether the sharp increases will feed through to higher NPLs.

  

- Japan  

As Our Man remarked last year, Japan is fascinating as they were the first country into a debt-deflationary spiral and there’s a reasonable chance that they may be the first country out of it.  Both of the key pillars of Japan’s strength, its savings rate and trade surplus, continue to wane and the new government appears very inclined to pressure the BoJ into further QE by setting a specific inflation target.

- US Political Intransigence (or Incompetence)  

Over the last few years, one sad truth has been that we shouldn’t underestimate the incompetence of politicians in Washington.  While 2013 seems to have started on a positive trend, with a fiscal cliff deal and an agree to increase the debt ceiling in the short-term, there’s ample opportunity for the sequester and budget hijinks to result in no deal and a government shut-down, or one that has imposes much austerity too quickly and only succeeds in pushing the economy back into recession.

- Negative Contagion  

One of the great positives of 2012 was that we arguably saw positive contagion, where positive developments spilled over from one area to the next.  The risk in 2013 is of negative contagion, where negative events in one region impact the others; such as a slowing Europe exacerbate the problems in China and Japan, which combined with a budget stand-off helps pull the US towards recession.

- Global Trade & Protectionism  

A holdover from previous years!  For those who are historically minded, the steady decline of Global Trade and the rise of protectionism was one of the noticeable features of the 1930's depression in the US.  With so many countries facing growth headwinds, and attempting to encourage exports, the temptation for domestic politicians will continue to be to blame foreigners and the rhetoric about punishing “cheating” (i.e. trade surplus) countries will remain.  Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!

- Demographics  

A long-term concern for Our Man is the weak demographics of the Western world.  While this is a major problem in Japan, China and many European countries, it’s also starting to impact the US.  In 2011, the US Birth Rate hit a historic low (it’s now about ½ the peak rate of the baby boom years) and the US fertility rate (1.9 children/woman) is now below the rate needed to maintain the current population.  Furthermore, the aging of the baby boomers will continue to have significant impacts on housing, employment and unemployment and investing.

- Corporate Margins & Valuation  

Another holdover from previous years!  While all the other ‘fingers of instability’ suggest risks to the global economies, it’s corporate margins and valuations that make the market particularly vulnerable.  While short-term measures (such as trailing P/E or the awful forward Operating P/E) suggest that the market is cheap/fairly valued they require the belief that the current level of margins (near all-time highs) is sustainable ad infinitum.  Perhaps they are, and we’re in a new paradigm but Our Man suspects that reality is that the elevated levels of margins offers more potential for downside surprise than upside opportunity.  While long-term measures of valuation are a terrible guide to any given year’s market performance, they do offer a valuable guide or map for real cheapness or value and they don’t suggest that the broad equity markets offer much in the way of absolute value.