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 9: EU SUMMIT
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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