2012 – proceed with caution

by Trevor Greetham, Asset Allocation Director at Fidelity

January 2012

This is likely to be a challenging year for investors as Europe is moving into a recession that will undermine global economic growth. This downturn in Europe will exacerbate the financing problems of peripheral economies and introduce contagion to the core banking systems as the eurozone crisis enters into a final, painful phase. Other developed economies are struggling to grow under high consumer and government debt burdens and are hampered by fragile banking systems. All in all, things look bleak in the near term. But 2012 does have the potential to be a V-shaped year for risk assets, if Europe can deal with its political crisis and the US economy responds to stimulus.

In effect, we are entering the New Year experiencing the second round of the global financial crisis. The first round was caused when banks and other highly leveraged financial institutions were uncertain of the value of complex financial instruments linked to sub-prime US housing obligations. This second phase is based on uncertainty surrounding the value of eurozone sovereign debt, a far more widespread asset with a critical role as a supposedly risk-free asset in the global banking system. In 2008, the threat of bank runs was stopped by government intervention; now we are seeing a crisis of confidence in European sovereigns that will require equally forceful action.

The bullish case for 2012 rests on a US-led economic upswing that is strong enough to offset anticipated weakness in the European economy and it assumes the worst-case scenario of a messy euro break-up can be avoided. US data has been resilient but, as things stand, it’s doubtful financial contagion from Europe can be avoided.

Global economic growth is slowing and a peak in inflation will enable central banks to ease policy with force. However, it will be hard to offset a synchronised slowdown in the EU, an economic area larger than the US or China. At the same time, the ability of the US to underpin global activity is constrained by political deadlock over fiscal policy and China is unlikely to fill the gap. China’s exports to the developed world are slowing and monetary easing is likely to be incremental as inflation is still an issue.

Wrong-headed

We began 2012 with our portfolios as defensively positioned as we were throughout 2008. One of the key reasons for our caution is that policy responses are making the European debt crisis worse. US investors have become used to a sequence of events that sees a panic on financial markets elicit a policy response that calms investors. In earlier times, people called this the Greenspan put. But what if the policy response is the wrong policy response?

Europe’s problems stem from a lack of competitiveness in the peripheral economies resulting in large trade deficits with the core that investors are no longer willing to finance. Policy makers are addressing the crisis by insisting on ever-deeper austerity, by threatening banks with injections of public capital and by hinting that countries that don’t follow the rules can leave the euro. These policies may do more harm than good.

Austerity is exacerbating the economic slowdown in peripheral economies, causing their fiscal dynamics to deteriorate in a vicious and unstable cycle. The peripheral European sovereign bond markets behave like corporate bonds. These states cannot print money to repay debts and they cannot devalue their exchange rates to restore competitiveness. When economic growth slows, bond yields rise as investors factor in a higher likelihood they won’t get all of their money back. This rise in the cost of government finance itself makes fiscal sustainability more difficult. A move into recession will certainly test the commitment to cut spending and it will test the resolve of Germany to supply further funding to what it sees are errant member states.

Offering banks additional capital sounds sensible but it is causing a credit crunch. Banks want to protect their share price so they are making every effort to improve their capital position by calling in loans. Talk of Greece or other countries leaving the euro creates uncertainty about the integrity of the single-currency area and causes investors to factor in a risk premium for possible foreign-exchange losses, even for bonds in the eurozone core.

Germany vital

A solution to the problem could come from a policy to rebalance the European economies with the European Central Bank intervening to maintain market discipline in the meantime. Trying to restore competitiveness by deflating wages and asset prices in the periphery is doomed to failure when debt levels are so high. It is far better to inflate the core. If policy makers are unwilling to do this; for example, by easing fiscal policy in Germany, then a much weaker euro exchange rate could do the trick by boosting German exports to the rest of the world.

The ECB could help such a transition by providing unlimited support to cap yield spreads in eurozone sovereign bond markets. Much depends on Germany’s preparedness to agree to a policy that could involve a large transfer of wealth from the core to the periphery. The German Bundesbank claims that buying bonds in an unlimited manner would be illegal, amounting to central bank funding of member states. The greater impediment may be fear of moral hazard: that the ECB intervention would signal to political leaders in the periphery that fiscal irresponsibility will not be punished.

For Germany’s opposition to this policy to become exhausted, we may need to see contagion spread to its financial sector and economy. This still seems some way off. The German unemployment rate is at a post-unification low of less than 7%; compare this with 23% unemployment in Spain and it is clear the German economy is simply not feeling the pain of its neighbours. Indeed, for now, Germany seems quite happy to live with, or even engender, a sense of crisis, as it allows them to push for structural reforms among their eurozone partners.

Once the crisis reaches Germany, the choices could become binary. A eurozone break-up is something that Europe’s premier manufacturing export base wants to avoid at almost all costs. There would be huge damage to Germany’s export and banking sectors from the appreciation of new Deutschmark. Monetary and fiscal easing to inflate the German economy and make it less competitive relative to the periphery may, ultimately, be a solution that Germany is prepared to stomach. The alternative would be full political union, perhaps with a smaller group of states, allowing for large fiscal transfers and coordinated economic policy. If and when we get bold policies like this, it could be time to become more positive on risk assets.

A recession in Europe will hamper emerging markets through trade and financial channels. European banks are the dominant lenders into Asia where credit growth has been a key driver of economic activity. Emerging markets will probably not be spared from volatility but a weak global economy in 2012 could provide a good long-term buying opportunity in much the same way as it did in 2008-09. When global growth starts to recover, emerging markets are likely to outperform developed markets by some margin.
It’s likely that investment conditions will remain difficult. We expect short violent economic cycles, driven by bouts of unprecedented fiscal and monetary stimulus. Diversification across a range of asset classes will remain an attractive proposition.