Thursday, December 22, 2011
2012 is not expected to be a breakout year for the economy, or for the markets.
U.S. Gross Domestic Product (GDP) is expected to grow no more than the economy’s potential rate; thus there will be little reduction in unemployment.
Earnings expectations for U.S. corporations are much more subdued for 2012 compared to 2011.
The European credit crunch could spread globally, and so too could the very probable current European recession.
The current message of our indicators is that the economic world as we know it will survive in 2012, and markets will continue to recover as the doom and gloom recedes.
Gloom and doom became the norm in 2011 as we endured end-of-the-world stories punctuated by concerns of the death of the Euro, the aftershock of the U.S. hyperinflation that never manifested, or the economic depression that did not occur. Take your pick; the news for 2011, while exaggerated, was – and remains – bad. There were few positive media headlines to sift through.
The end-of-the-world chatter and contagion talk has continued to weigh down consumer confidence globally. Worried investors have continued to seek the comfort of the herd, acting in unison. The result has been the unprecedented number of one-sided trading sessions since the Waterfall Decline of early August, the event that changed everything for the rest of the year. The vast majority of shares and stock prices have been moving in the same direction, with the daily gyrations – both up and down – unusually high over the last five months. At the same time, correlations remain higher than ever, with the risk-on beneficiaries outperforming together on rallies and the risk-off indices outperforming together on sell-offs.
The believers of the end-of-the world scenario would argue that fear is justified, that global market and economic deterioration will be reminiscent of 2008, or even worse. But the flaw of that argument is that the 2008 experience, together with the widespread awareness of the carnage that a Euro break-up would bring, virtually assures that the world’s major policy-making bodies will do whatever they can to prevent it.
Political feuding and global coordination hurdles are likely to draw out the process and make it more of a muddling process of repair than a quick fix. To the extent that the process will continue to include monetary accommodation, the markets will stand to benefit from the increased liquidity when the gloom and doom gives way to rising confidence that the global economy is not as dire as the markets had thought. When pessimism has been at such high levels, equity investors have been susceptible to positive surprises. The pessimistic crowd sentiment has bullish implications.
Also encouraging is the market’s recent zig-zag, reflecting a momentum thrust from an oversold condition. By itself, the late November streak of seven straight down days was a positive omen. The market has usually been higher over the three-, six-, and 12-month periods following past streaks of seven straight down days. And it has been especially encouraging to see that streak followed by a five-day gain of more than 7% on the S&P 500. Prior to 2011, there were four other cases when a seven-day losing streak was followed by a five-day gain of at least 5% during the next two weeks, in 1942, 1962, 1974, and 1982. Each case occurred within four months of a cyclical low, and in the 1942 and 1982 cases, a secular low.
Despite the rarity of such reversals, the latest case is actually the second in four months, following a similar reversal after the selling climax in August. The back-to-back cases exemplify the market’s gyrating tendency, and they are in keeping with the other signs of a market that has reached the extreme of worry.
If contagion from the Euro-Zone debt crisis is in fact contained to Europe, then the comparisons with 1998, when Asian contagion stopped, will remain more relevant than comparisons with 2008, when U.S. contagion did not. In 1997-1998, the U.S. stood at the outskirts of the contagion as the Thai baht devaluation led to currency meltdowns, collapsing markets, a liquidity crisis, and economic contraction throughout Southeast Asia, leading to an oil price drop that triggered the 1998 Russian default and, in turn, the demise Long-Term Capital Management. The period included a series of IMF bailouts and ultimately a Federal Reserve bailout to stop the contagion, with successful results.
Ten years later, the U.S. stood at the epicenter of an escalating financial collapse that spread globally. The U.S.-driven financial contagion produced a global bear market with the worst declines since the 1930s. The market carnage anticipated the longest recession since the 1930s and the biggest earnings collapse on record. With the world’s largest economy and market cap, the U.S. dragged down markets and economies around the world.
With an end-of-the-world scenario unfolding in Europe, the credit crunch could spread globally, and so too could the very probable current European recession. Currently, however, recessions do not appear likely beyond Europe (at least due to European contagion; admittedly, there remain other factors in the U.S. which must still be contended). Keeping in mind that the stock market leads the economy, the relative market performance suggests that the European economy will underperform. But that does not mean a global contraction lies ahead. In 1997-1998, the MSCI Pacific excluding Japan Index underperformed decisively as the U.S. outperformed. Likewise in 2010-1011, the MSCI Europe excluding U.K. Index has underperformed the U.S. decisively.
We have been positioned for U.S. relative strength and Euro-Zone weakness, having remained overweight the U.S. and underweight Europe for 2011.
The most optimistic scenario is that the U.S. market could be expected to rise toward a test of the 2007 highs, in the range of 1500-1560 on the S&P 500.
What if we are wrong and the 2012 doomsayers are vindicated, at least about the stock market? In that case, our indicators and models will warn of trouble and we will cut exposure to equity in response. But the current message of our indicators is that the world as we know it will survive in 2012, and markets will continue to recover as the doom and gloom recedes.
The Bearish Case
If 2012 fails to be the bullish year that we expect, then the warnings will soon be evident. December-January has tended to be the year’s strongest two-month period. So a failure to perform in line with the seasonality would point to underlying problems. With a year-end rally fizzle that leads to a less-than-stellar January, we would be concerned with a less than robust Presidential Election year. (The Dow Jones Industrial Average (DJIA) has risen by an average of 12% in the election years when an incumbent has won and fallen by an average of -3% when the incumbent has lost.) One of the better known end-of-the-year adages is “If Santa Claus should fail to call, bears will come to Broad and Wall.” Thus, hopes are especially high for a Santa Claus rally this year to validate contentions that the bull market from 2009 remains intact.
Not to make political predictions, but a loss by President Obama could be inevitable if a European contagion starts to appear unstoppable, bond yields continue rising across Europe, banks face further losses globally, their stock prices break down, all indicators predicting a global recession. And if that year end / beginning of the year rally does fizzle out, it may be predicting worse things to come.
These “worse things to come” scenario would make comparisons with 1998 less relevant than comparisons with 2008, when it was the U.S. that spread the recession. A Euro-Zone breakup and ensuing currency crisis would choke off trade and make the European recession global in scope. It would then be clear that instead of a cyclical bull, the market would be in the second phase down of the bear market that started with the early August waterfall decline of the stock market.
After breaking through the October 2011 low, the S&P 500 risks would be down in the 870-900 zone. A drop to that level would leave the S&P 500 down by -34% to -36% from its April high, consistent with the market carnage experienced in past cyclical bears that have taken place within secular bears.
The 2012 global economic outlook is dominated by the three largest contributors to global growth: the U.S., Euro-Zone, and China. The U.S. economy may take a hit in the first half of the year, particularly if fiscal stimulus, such as the payroll tax cut and extended unemployment compensation, is not renewed. Europe will continue to be plagued by the sovereign debt crisis, while China will do its best to cope with slowing exports.
The Euro-Zone sovereign debt crisis will continue to see its ups and downs, with European officials doing the minimum to keep the Euro-Zone from disintegrating. The proposals presented at the December 9th European Union summit are positive steps toward a fiscal union and necessary for the survival of the region. We think this is just the beginning of fiscal integration and we’ll likely see more proposals in the future. To regain market confidence, however, there still needs to be a sufficient back-stop in place, such as more European Central Bank (ECB) bond buying, as well as International Monetary Fund (IMF) loans (including the latest IMF proposal for 200 billion Euros). These are not solutions to the sovereign debt problem, but will buy the Euro-Zone time, as the move to fiscal union through needed austerity and debt reductions will take several years.
With that being said, the best-case scenario for the Euro-Zone next year is a normal recession. Germany has essentially been holding up the area’s economy. But with nearly half of Germany’s exports going to other Euro-Zone countries, which have been forced to undergo austerity and face tighter credit standards, we don’t see how much longer Germany’s economy can be left standing. Numerous economic indicators from Germany and the Euro-Zone as a whole, have been pointing to recession, if not now, then sometime early next year.
China’s economy will experience a soft landing next year. Broad economic measures have been slowing, but are not yet giving an indication of a 2008-type hard landing. Exports are one major weak spot in the economy, pulled down by slowing demand from the Euro-Zone, one of China’s largest trading partners. The People’s Bank of China’s recent move to cut large banks’ reserve requirement ratio will help stimulate the economy. We believe there will be more to come.
China and other emerging economies are expected to lead global growth. Of course, given that the globe is fraught with risk, it is also important to recognize that should indicators turn further south that the biggest risks also lie in the emerging economies. Easing central bank policies will help support expansion in 2012. Emerging economies should benefit to a larger degree, as they have more room to stimulate growth and cut rates, whereas developed economies have exhausted the most effective tools in their monetary (and in some instances, fiscal) toolboxes.
Global Macroeconomic Risks
Clearly Europe is the biggest risk to the global economy. At this point, we see the dissolution of the Euro-Zone as a remote possibility – very remote for 2012 – but that does not mean the markets would not price in that possibility prior to the event.
The cost of disintegration would be too high for the member countries and the world relative to the benefit. Although many investors expect Greece to leave the Euro-Zone by the end of 2012, we believe that such a move would have dire consequences, as it would open the door to the possibility of more countries exiting and thus possible disintegration. There’s also a risk that markets will turn their attention to other debt-ridden nations, such as the U.S. and Japan, which share similar, if not worse, debt positions than Europe. But we argue that the European debt crisis has as much to do with the lack of fiscal union than it has to do with debt.
We expect a reduction of global trade volumes in 2012, due to the spillover effect of the European debt crisis. Possible protectionist measures imposed because of the trade slowdown could also pose a risk to global growth next year. Trade wars ensued following the 2008 downturn, which stalled the global economic recovery.
2012 U.S. Economic Outlook
As 2011 ends, the U.S. economy is accelerating. Gross Domestic Product (GDP) is tracking above 3% annualized in the fourth quarter (Q4), up from 2% in Q3 and closer to 1% during the first half of the year.
Assuming the economy does not suffer from large exogenous shocks and at least some of the expiring fiscal stimulus is renewed, we expect that the economic expansion will continue in 2012 – albeit weakly. Most of the GDP components should contribute to growth. Additionally, 2012 is an election year, which could reduce economic uncertainty and provide a basis for business and consumer optimism.
Given our assumptions, we project GDP growth of about 1.5%–2.5% for 2012. (The Livingston Survey is at 2.2%, Blue Chip Survey is at 2.5%, and the latest Federal Reserve forecasted range is at 2.3%-3.5%.). Our estimate is based on two top-down approaches (one with a full data history, and the other with the past ten years of data only) and uses our projected ranges for six key indicators.
Given the uncertainty in the economic and political climate in the U.S. and abroad, we considered two scenarios for next year: optimistic (extended fiscal stimulus, modest Euro-Zone recession with limited financial contagion, and continued economic growth) and pessimistic (fiscal stimulus is left to expire at yearend, the Euro-Zone enters a deep recession with widespread contagion, and global growth slows considerably). Our estimated range is a weighted average of the two scenarios, ascribing a higher probability to the optimistic case.
Personal consumption expenditures, which account for over 70% of U.S. GDP, will remain positive, rising about 2.5%, predicated on the assumption that the employee payroll tax holiday and the emergency unemployment compensation (EUC) are extended for another year.
Pent-up demand for automobiles, along with easier borrowing terms and rising used vehicle prices, should support new vehicle sales. High-end consumer spending should remain solid, particularly if the stock market performs well. Headwinds, however, remain. Disposable personal income growth has moderated over the past year and consumers have reduced savings in order to maintain spending. As a result, the personal savings rate fell to 3.5% in October from 5.2% at the start of the year. It could revert back to the 5.0% level, if the economic outlook becomes more uncertain. Although the unemployment rate fell to 8.6% in November, we do not expect it to decline much further in 2012. The Federal Reserve projects it will range between 8.1% and 8.9% for 2012. Such an elevated level could also weigh on personal income growth.
Fixed private investment should continue to grow, albeit at a more modest pace in the mid-single digits. Equipment and software spending, which was aided by the 100% bonus depreciation in 2011, could pull back as the qualified expensing is scheduled to be reduced to 50% in 2012. Even so, with record profit margins and sustained improvement in credit conditions, firms can continue to increase business spending if they see favorable demand trends for their products. Inventories should continue to run in line with sales.
There are several main risks to our economic outlook for 2012. First, as the economic expansion remains subpar and aggregate demand is still weak, letting the current fiscal stimulus expire at year end could restrain economic growth. We estimate that the end of the employee payroll tax holiday and EUC would subtract about one percent from 2012 GDP growth. Second, further deterioration in the sovereign debt crisis in Europe and a possible recession in the region could reduce U.S. growth throughout financial contagion and lower exports to the region and elsewhere. Third, slower global growth could reduce global trade negatively, impacting U.S. exports.
2012 U.S. Inflation Outlook
We expect inflation measures in 2012 to remain well contained. We used a two-pronged (top-down and bottom-up) approach in formulating our forecast. The top-down perspective projects 2012 inflation of 2.8%, while the core rate is expected to be 1.6%. The bottoms-up perspective, which is based on individual Consumer Priced Index (CPI) components results in an overall inflation outlook of 2.3%. Averaging the two forecasts gives an estimated 2.5% inflation rate for 2012%.
If the economy veers toward the recessionary scenario we noted in our growth outlook, then aggregate demand will soften, putting downward pressure on prices.
Beyond 2012, the longer-term risk is for higher inflation, particularly if the large monetary accommodation from the Fed is not withdrawn in time as unemployment gradually shrinks. Furthermore, the explosion of federal debt has the potential to spur inflation if the government does not take timely measures to improve its long-term fiscal position.
Earnings expectations for U.S. corporations are much more subdued for 2012 compared to 2011. Consensus estimates for the S&P 500 are 9.9% for Generally Accepted Accounting Principles (GAAP) earnings per share (EPS) growth, and 10.5% for operating EPS growth next year. As recently as late May, GAAP growth estimates for 2011 were 23.7%. Currently they have come down to 15.5%. In fact, Q4 2011 would mark the first time in two years that year-over-year GAAP EPS growth has been below 20%.
Bottom Line: A Road Map for 2012
Although we are likely to start 2012 with a modestly bullish tilt to the U.S. equity market, we intend to take a more cautious view of the year’s first half until there is a better entry point to increase risk. For the full year, we expect a bullish outcome. However, significant event risks remain which are likely to shape the direction of the market. We categorize that direction into three stages: the Gravity Test, Potential Risks, and the Election Rally. To be sure, while we think this year’s roadmap is a reasonable expectation, it is only our best guess for where we may make adjustments to our sector and asset class allocations (i.e. more growth-oriented, or less growth-oriented). Actual adjustments will, of course, be determined by our indicators as the year progresses.
Gravity Test (January – April). Fueled by heavy pessimism from the latter half of 2011 and now current favorable seasonal tendencies, our roadmap suggests the market should remain buoyant through April, although post-waterfall studies (again, the market experienced a rare waterfall decline in early August 2011) argue that we should not get back to the prior bull market highs (1,365 points on the S&P 500) until April-May of 2012 at best. Until then, our best guess is that we are range bound between 1,100 and 1,365. Accordingly, we are largely satisfied with our current portfolio allocations, although we are open to making opportunistic adjustments.
Potential Risks. Our roadmap also alerts us to potential market weakness in the April – July period, especially if additional fiscal or monetary stimulus is not forthcoming. Europe also remains a risk, along with rising global tensions which can quickly bring unknowns to the forefront. If such risks are realized, a mild U.S. recession may ensue, along with a bear market. Under this scenario, our historical studies suggest further downside risks to around 900 to 1,000 points on the S&P 500. The tell-tale sector leadership signs to watch would be if defensive sectors (Staples, Health Care, Utilities, and Telecom) began to outperform business spending sectors such as Industrial and Technology.
Election Rally (A Potential Entry Point for Risk Assets). Nearly July, especially if we get an earlier sell-off, we will look to turn our sector selections more aggressively for the start of the presidential election rally, and possibly the start of a new cyclical bull market. Historically, sectors that have outperformed during the first third of new bull markets include the cyclical Consumer Discretionary, Industrial, Materials, Financial, and Technology sectors, while defensive sectors have underperformed. We will look for this leadership as an indication of more favorable conditions.