2012: 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?)

In the absence of major Quantitative Easing from the ECB (see Glimmers), which would reflect a transfer of risk from the individual sovereigns to the Euro-collective, Europe’s debt problems are likely to continue apace in 2012.  However, unlike 2012, the uncertainty may spill over more into the real economy and if European banks retrench (which the ECB’s LTRO’s seem designed to prevent) and we could easily see a Europe-wide recession.  The knock-on effects of this both within Europe and globally, are likely substantially under-appreciated!

- Political (and Social) Instability

History suggests that political instability increases during economic downturns, and Europe is likely to see its fair share be it through more elected governments being replaced by unelected technocrats (see Italy and Greece), or some of these technocratic governments falling from power when it becomes clear their policies are (intentionally?) better for “the European project” than the people they’re supposed to represent.  For Europe, an economic recession (especially one that hits Germany and France) may make QE by the ECB more palatable, but it also increases the prospect of French/German citizens becoming less willing to support further bailouts for the PIIGS.   This of course, doesn’t even consider the further issues we’re likely to see in the Middle East (especially Iran) and Asia (North Korea).

- China (and the rest of the BRICs)

As I’m sure you’re all well aware, Our Mani skeptical of the Chinese growth miracle and believes that while they’ve mastered the art of creating GDP-growth but are failing to create wealth due to the credit-fueled malinvestment that’s driving the GDP-growth creation.  Rather than bore you with more of the same, I’ll point you in the direction of a previous post and leave you with one additional thought; in global recessions (and especially debt-driven depressions), it’s the trade surplus countries that suffer the most, as they’re more reliant on foreign demand and at risk as foreign countries try to support and protect their domestic industrial base (e.g. the UK suffered an 8-10% fall in GDP during the 1930’s depression, whereas the trade-surplus US suffered a GDP fall of 3x this!).

- Global Trade & Protectionism

On a related noted, and especially 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!

- Japan

 Japan fascinates Our Man, in part because 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.  What’s intrigues Our Man is that two of the pillars of Japan’s strength, its savings rate and trade surplus, are both fast waning.  The savings rate has been steadily declining from over 15% in the early 1990’s to c2% today, and 2011 saw Japan’s first trade deficit in almost 50yrs.    Though all eyes are focused on Europe at the moment, Our Man’s guess is that it’s Asia (China or Japan) that will prove to be the interesting story of 2012.

- Corporate Margins & Valuation

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) are 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.