Friday, December 2, 2011

Market Review and Outlook: December 2011/January 2012

Outlook: December 2011/January 2012

Act Now! Don't Delay!

The past year has been characterized by a series of false starts that ended in successive failures to restore confidence in the economy and markets. The shaky global economy, battered by the 2008 financial swoon, kept trying to get up off the mat only to be clobbered again by prevaricating politicians who failed to lead us out of crisis and by a series of once-in-a-generation events, which never allowed markets to gain any traction. The Japan earthquake, the Arab Spring, the debt ceiling debacle in Washington, and round two of the Greek crisis cut short nascent rallies in confidence. The equal and opposite reaction has been a mounting pile of uncertainty, growing as fast as the debt levels in troubled economies.

The failure to restore confidence has led to subpar growth in the G7 which is starting to erode the Asian economic boom as well. Economists have trimmed growth expectations for this year and next, with many now predicting Europe is bound for recession, which could in turn drag the US into a double dip, and dent China which relies on Europe as its biggest export market.

In the face of these dark clouds gathering, political leaders are failing to act boldly on a global scale. Washington remains at loggerheads over the most meager deficit reduction plans, Beijing has only started to realize it may need to brace for a hard economic landing, and Brussels keeps putting off its day of reckoning by agreeing to "plans for a plan." Central banks have papered over some of the politicians' mistakes, but can only do so much. The global economy will continue to suffer and may even spiral lower if political leaders continue to kick the can down the road and don't rally at this perilous moment to enact forceful strategies to restore confidence.

Time is a Precious Commodity

For most of the summer, the slide in confidence was a boon for gold investors, but the yellow metal has lost its luster as the "alternative currency" in recent weeks. Initially gold started selling off as a way to pay off margin calls in other asset classes, but it has failed to reignite even as volatility and risk-averse behavior has persisted.

Crude futures have outperformed precious metals over the last two months, gaining over 25 percent and topping out over the $100/barrel mark for the first time since July, when the recovery had seemed more certain. At the century mark, crude prices could become another drag on the economic rebound. Energy prices may in part be responding to the growing tensions between the West and Iran after a new IAEA report indicated that Tehran has not wavered in its aspirations for weaponizing its nuclear program. The report triggered a new round of sanctions against the Iranian regime including some of the first aimed at crimping its oil export business and was fodder for renewed speculation that Israel or even the US might resort to bombing Iran's testing facilities. Since the IAEA report, there have been reports of two mysterious explosions near Iranian nuclear and missile bases, fueling the chatter that covert actions may already be underway against Iran. For its part, the government in Tehran has threatened to counterattack against newly installed NATO early warning radar systems in Turkey at the first sight of foreign warplanes.

Beyond Iran, the undercurrent of upheaval that started during the Arab Spring has never really subsided. Iran's satellite state, Syria, while not an oil rich nation, threatens to further destabilize the region as deserting soldiers have formed the core of an armed revolution against the Assad regime. Meanwhile Cairo's Tahir Square has filled will protestors against the military junta that took over after Mubarak was deposed, even as Egpyt begins a four month, 12-round voting process, the largest democratic exercise ever undertaken in the Arab world. The protestors fear the election procedures that have been set up are flawed and will not require the military to fully cede power. Thus the vote is no guarantee that violent clashes will subside.

These remnants of the Arab Spring form the backdrop for the next meeting of OPEC ministers in Vienna on December 14. The last OPEC conclave six months ago ended in delegates storming out of the meeting, unable to agree on quotas and with Saudi Arabia unilaterally boosting its output to offset production lost to Libya's civil war. This month's meeting may be more conciliatory, as members are likely to maintain their overall quota, while making allowances for the ramp up of Libyan oil output, which has already reached about half of the 1.2M barrels per day that it produced before the uprising against Gaddafi.

Buying Time

The global recovery has been hamstrung by a record year for natural disasters, from hurricanes and tornados in the eastern US running up insurance payouts, to the Japan tsunami causing destruction and supply chain disruptions, to the floods in Thailand that sent the tech industry scrambling to replace lost production. US companies reporting decent Q3 results, solid Black Friday retail sales, and fund manager's playing "catch up" -- racing into the year end to get their lagging performance in line with the benchmark S&P performance -- have helped maintain a floor in equities. This autumn, hopes that the noises out of Europe could gel into a real crisis resolution plan bought more time before traders punished political inaction. After the surprising October rally in equities fueled by the "hope trade," stocks turned more cautious, selling into rallies.

With confidence under continuous assault from the headlines and the housing market indefinitely in the gutter, the key measure for the temperature of the US economic climate remains the employment figures. In the last month, weekly jobless claims have been trending lower with the four-week average firmly below the psychological 400 thousand mark. The monthly data has been less encouraging with unemployment remaining stubbornly above nine percent, and non-farm and private payrolls unable to exceed a listless 100 thousand pace. It is widely accepted that it takes a growth pace of over 200 thousand to make headway on unemployment while absorbing new entrants to the job market. Even with seasonal hires at holiday retailers, the consensus estimate for non-farm payrolls is under 150 thousand when the next data point is released on December 2.

If data trends continue to tread water or sink beneath the waves rippling out of Europe, the Federal Reserve may find itself shouldering the burden of more unilateral stimulus. Markets have been egging on the Fed to deliver a QE3 program, and the expectation that the central bank will conduct more asset purchases has helped undergird the markets to a certain extent. The Fed has done little to dispel this expectation, and indeed at the last FOMC press conference Bernanke's responses intimated the Fed now has QE3 on a hair trigger in case of a severe downturn that could come from a European collapse or other exogenous event. Bernanke also reiterated, however, that the Fed cannot go it alone and Congress needs to get cracking on a fiscal consolidation plan, though that call continues to fall on deaf ears. Still any QE3 announcement is likely to be put off until next year given the Fed's historical tendency to abstain from policy action during December.

In this continually uncertain atmosphere, retailers seeking to build on positive Black Friday sales, face a wildcard event that could play the Grinch this season. Three unions representing about a third of America's rail workers have been unable to reach a contract extension with Union Pacific, CSX, and Burlington Northern and a strike action is possible if there is no deal by the end of a cooling-off period that ends on December 6. With this deadline threatening next month's peak shipping season, retail and auto industry representatives have asked President Obama and Congress to broker the talks, but it could become another political football as it pits corporate and union interests against each other.

The Waiting Game

The Confederacy of Dunces in Washington D.C. imagine that the 2012 elections will solve their political gridlock, either by fulfilling the Republican's avowed goal of making Obama a one term President, or by handing Obama a mandate for deficit reduction that accepts tax increases a necessary component. The half hearted efforts of the ill-conceived Supercommittee are illustrative of this belief on both sides of the aisle. Immediately after the committee failed, the volleys of accusations between Democrats and Republicans on Capitol Hill resumed. Some Republicans, nervous about automatic cuts in defense spending triggered by the Supercommittee's failure to draft larger deficit reductions, have begun looking for ways to undermine the so-called "sequester." Such efforts appear to be a non-starter though as the President has vowed to veto any efforts to scale down the $1.2T in cuts required by the sequester.

The next round of politicking on Capitol Hill has begun already as Democrats have proposed extending the two percent middle-class payroll tax cuts set to expire in 2012, funded by a surcharge on people making over one million dollars a year. Republicans who have held the line on new taxes all year, and fear the repercussions of defying the Grover Norquist anti-tax pledge, are reluctant to bend this time either, counting on Democrats to fold again and agree to offset the payroll tax cut with more spending reductions. Another bargaining chip before Congress in December will be whether or not to further extend unemployment benefits. Taken together, the unemployment benefits and the payroll tax break would have a one percent impact on GDP in 2012, enough to make the difference between modest or anemic growth.

Another month of partisan bickering over how to fund the payroll tax extensions could trigger renewed US sovereign downgrade chatter -- after all S&P based its US downgrade in August chiefly on the political climate, and Fitch and Moody's have also scolded Washington for its partisan antics. Yet the deadlock in D.C. has gotten so poisonous that the two parties seem resigned to kicking the can down the road and letting the 2012 election decided the way forward, even at the risk of a fresh ratings downgrade unleashing the nightmare scenario.

I'll Gladly Pay You Tuesday...(For A Bailout Today)

Sovereign downgrades have become a monthly occurrence in Europe where contagion has swept through the periphery -- Ireland, Portugal, Greece, Spain and then Italy -- and now threatens to enter the core nations of France and Germany. French banks have been under pressure for months because of excessive exposure to Greek debt, and another warning sign was seen in the failure of Franco-Belgian bank Dexia, which had to be nationalized in October. Belgium was downgraded recently by S&P and France is forced to rebuff rumors about losing its AAA-rating on an almost weekly basis. Meanwhile, Germany had its biggest scare to date in the technical failure of a debt auction in late November. While this was not the first bund auction to go technically uncovered, it was ill timed as it came amid reports that foreign investors have started to reduce their holdings of German debt, shying away even from the bedrock of the Euro Zone until the crisis comes closer to some sort of resolution.

In the periphery, the situation in Greece has been put on the back burner for the time being after finally meeting the requirements for its 6th aid tranche in December. Funding issues may arise again early next year when Greece must again meet muster for its next aid payment (the Greek finance ministry has stated that it needs the 7th aid tranche before the end of February). The core euro zone nations have made it clear that the Greeks will have to make a conscious choice to toe the line or face a renewed consideration of an orderly exit and default.

With Greece off the front pages, Italy became the focus of concern. Despite complying with demands for additional austerity plans and the ouster of their flamboyant PM, Italy's borrowing costs have become unsustainably high. Recent reports allege that the IMF has been pulling together up to six hundred billion euros for an emergency aid package that could prop up Italy if necessary. This report has been denied repeatedly by officials, but versions of it continue to resurface in the press, with the latest suggesting the IMF might have only one hundred billion euros to spare if Italy comes calling for aid.

Meanwhile the efforts to beef up the EFSF bailout fund have been forced toward more meager goals. The original plan to leverage the EFSF by up to five times to over one trillion euros, has been deflated by a decidedly cool reception from investors wary of the lack of political will in Europe to unite behind a grand salvation plan. EFSF officials toured Asia hat in hand, but returned with little to show for their efforts, and there was even a report (which were quickly denied) that the EFSF was forced to buy some of its own debt to pad fund raising results. This has led officials to concede the leveraging may only reach two or three times and could require additional incentives for investors, including limited guarantees against losses (on the order of 20-30%). EFSF chief Regling has stated that the fund will go to the markets in December, but expects to go it slow, cautioning that he does not expect to raise hundreds of billions in funds in December. The progress of this fund raising bears watching this month, as it will be closely tied to the level of outside confidence in the Euro Zone, which currently remains very low.

European leaders can't seem to get in front of the downward confidence and debt spiral, unable to agree on the path forward. Most EMU members want to move toward joint euro bonds and designating the ECB as the lender of last resort, but German Chancellor Merkel remains unwilling to support these irreversible steps given that the German people would have to foot most of the bill. Berlin has been resolute in its stance on these issues, but a shift may be underway. Within the last few days one of the so-called German "wisemen" suggested that the ECB may indeed have to take up the mantle of lender of last resort if politicians fail to craft a better plan, reflecting the sentiment of many observers who feel the central bank will inevitably be drawn in to that role.

Is China Stalling?

On the same day that G7 central banks announced coordinated action on dollar swaps to ensured liquidity would not seize up in Europe (Nov. 30), China's central bank cut the reserve requirement ratio (RRR) for commercial lenders for the first time in three years. The 50 basis point cut was the first reduction in the RRR after a campaign of twelve hikes over the last two years, and clearly an effort to ease strains in the domestic credit market and give a boost to a slowing economy. Market reaction was positive to this quasi-coordinated move, though bears suggested the Chinese cut the reserve ratio to preempt a bad reaction to another contraction seen in manufacturing data that came out less than 24 hours later.

Over the course of 2011, China Manufacturing PMI data has trended downward, revisiting multi-year lows several times, culminating in a near three-year low in the most recent data. This descending data series was in part engineered by a year's worth of policy tightening directed from Beijing in a reasonably successful effort to avoid overheating the economy. The RRR cut signals that government planners have begun to fear a slowdown more than inflation.

Inflation pressure has been a more stubborn problem for China, fueled by strong growth but also by domestic real estate speculation. Chinese CPI has moderated slightly in recent months after peaking at an uncomfortable 6.5 percent in July. The next round of China inflation data is due out on December 11, and hopes are that the trend will continue to moderate alongside the tempered economic growth rate, but they may be thwarted as industrial commodity prices have been trending higher lately, led by oil.

If Europe and the US contain their woes, the Asian economic boom that has kept the global system afloat for the last few years may take its turn facing market scrutiny in 2012. Though official Chinese data paints the picture of a soft landing in which the state has beaten back inflation and maintained an impressive growth rate, some empirical evidence belies this success story.

Indications of a potential hard landing are most evident in the Chinese real estate market. Widely published reports document the ferocious real estate investment activity that largely precipitated China's policy tightening cycle and resulted in the construction of whole cities in remote provinces that are virtual ghost towns where most of the sparse populace has been engaged in money lending to support continued property speculation. Indeed real estate investment now accounts for about 10 percent of China's GDP, but policy changes have started to curb this activity, and some Chinese have begun to worry that a housing bubble is about to be pricked as it was in the US three years ago.

Compounding the concerns about growth next year, China is heading into its Lunar New Year holiday, known as the Spring Festival. The year of the Dragon begins on January 23, 2012, and festivities usually extend for two weeks, meaning much of China will be in holiday mode through early February. This could exacerbate the slide in manufacturing data on a year over year basis.

The Can Has Been Thoroughly Kicked

Meanwhile, Europe has no time to go on holiday. Central banks have shown they will act in the absence of government action, but their tools will ultimately fail without it. Again and again, European leaders have put off the painful decisions that need to be made to right the Euro Zone. The most recent supposed deadline that was allowed to come and go without a resolution plan was the November G20 meeting in Cannes. The latest pronouncement out of Brussels came from the EU's finance commissioner Olli Rehn shortly after the coordinated central bank dollar swaps action on November 30. Rehn warned that within the next ten days leading up to the EU summit leaders must conclude the crisis response with a plan for completing deeper economic integration or face the gradual disintegration of the union. After dozens of such decrees for senior European officials in recent months, it remains to be seen if Rehn is crying wolf again.

Not long after Rehn's t-minus 10 declaration, the ECB's new President Draghi indicated that the central bank could be persuaded to provide more direct support if the member states accelerate plans for modest integration efforts sooner rather than focusing on sweeping integration later. Under its new leader, the ECB has already brought its independence into question after it reversed a tightening course and cut interest rates, nominally to support flagging economic growth. Sensitive about questions of its independence, the ECB has been very reluctant to be drawn into the role of the EMU's "lender of last resort" to governments as the Fed does in the US. If the Euro Zone grand plan offers enough accountability for members who violate its terms, the ECB may be ready to accept treaty changes that would broaden its role and allow it to support the EFSF backstop mechanism.

After all of these delaying tactics, the foundation for greater integration may finally be laid at the December 9 EU summit. The latest proposals are steering the Euro Zone toward strict rules for taxation and spending with real enforcement backed by courts. If Chancellor Merkel can shepherd her colleagues into a more binding union, trading some sovereignty for more stability, the Euro Zone may emerge stronger. But timing will be crucial in formulating this master plan; the first steps of integration must be rapid enough to assuage markets and convince the ECB to give its blessing, but still rigorous enough to ensure weaker EMU members will not drag the union back into crisis by flouting fiscal rules.

Never Put Off Until Tomorrow...

Until a convincing crisis resolution plan is in place, Europe will remain the focus of global markets. The only way to save the Euro Zone in its current form seems to be to go all in, compromise the independence of the central bank, and pledge German's sovereign status to defending the euro. But Germany and the ECB appear determined to take this plunge only when it is on their own terms.

Merkel has insisted that the way forward is to incrementally tighten the political and fiscal structures of the member states to compliment their monetary integration. But this process will require extensive treaty revisions and ratifications in the 17 EMU parliaments, which the EFSF approval earlier this year demonstrated to be a laborious process.

Instead, the practical solution that is taking shape is to take a smaller but still meaningful integration step in the near term. A series of dilatory tactics -- the latest being the coordinated central bank swaps action -- have bought some time, but market patience may soon wear thin. This global version of the 'Bernanke put' may allow political leaders to kick the can yet again, but as bank chiefs have often stressed, they cannot go it alone without earnest and credible efforts from governments. Ultimately, political leaders must do the job of forging sensible fiscal consolidation plans that can steer their economies out of this mess. A prolonged political stalemate will only stall growth in developed nations, and exacerbate imbalances in the emerging markets.

Chancellor Merkel's strategy meetings with Sarkozy and top EU officials in the coming days could set the table for a Santa Claus rally. If she outlines a credible plan for a rapid and moderately-scaled integration ahead of the EU summit (Dec. 9), it could restore much of the confidence that has been drained away since this summer. Market action headed into December indicates that the traders are giving credence to Europe's latest effort, but if the new plan is once again lacking details or impetus, markets may not be as forgiving this time around. Greater Euro Zone integration will necessarily require strict adherence to fiscal consolidation and austerity programs, a sure recipe for more economic contraction in the short term, but that is surely a better outcome than the collapse of the euro.

Calendar of Notable Events

Nov 28: first round of Egypt elections
Nov 30: China Manufacturing PMI and HSBC PMI

Dec 1: US ISM Manufacturing PMI
Dec 2: Merkel speech outlining EU Summit proposals
Dec 2: US Payrolls and Unemployment
Dec 5: US Non-Manufacturing PMI
Dec 7: German Industrial Production
Dec 8: ECB rate decision and press conference; MPC (BOE) rate decision and statement
Dec 11: China CPI, PPI, and Trade Balance
Dec 13: FOMC rate decision and statement; US retail sales; BOJ Monthly report; German ZEW economic sentiment
Dec 14: Euro Zone CPI; OPEC meeting
Dec 15: US PPI
Dec 16: US CPI
Dec 20: BOJ policy statement and press conference; German Ifo Business Climate
Dec 22: US Final Q3 GDP; UK Final Q3 GDP; China HSBC Flash PMI
Dec 23: US Durable Goods Orders; US New Home Sales
Dec 26: US and Europe markets closed for Christmas holiday
Dec 31: China Manufacturing PMI

Jan 2: New Year's Day holiday observed
Jan 3: US ISM Manufacturing PMI
Jan 6: US Payrolls and Unemployment
Jan 18: US PPI
Jan 19: US CPI
Jan 23: Chinese New Year (Year of the Dragon), Golden Week
Jan 25: FOMC policy statement and press conference
Jan 27: US Q4 advance GDP report

Feb 3: US Payrolls and Unemployment

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