It helped that there was good news out of the US and Asia – retail sales were strong in the US with higher than expected growth and a slightly improved unemployment situation. Industrial output in China was also better than expected, and with lower inflation than many feared.
European news was mixed, but investors seemed to focus on the good: mainly the strength of the German economy, which has remained strong and where record lows of unemployment were reported for December. The bad news from the periphery markets didn’t seem to make too much of an impact.
That’s all set to change.
The “good feeling and cheer” of the holidays is rapidly dissipating and I predict European markets are getting ready for a tumble in the first quarter. Investors remain skeptical of European solutions and periphery debt, and it is too much to hope that 2012 will be a calm year in the rest of the world while Europe continues to muddle along.
There are four key factors that will fuel investor fear over the next few months:
- European recession. Europe is well and truly in a recession now, a fact that was partially hidden by Germany’s good performance. It seems unlikely that the Germans will be able to carry the rest of the continent much longer. Spain, Portugal, Italy, Greece are all contracting, thanks to the madness of austerity for sake of German voter support. France is also expected to experience at least one quarter of contraction. The macroeconomic news from the region will only get worse and when Germany cools off, investors will suddenly realize just how bad things are;
- Continuing debt crisis.The euphoria of the “definitive solution” from the 9 December summit lasted a little over a week, and now, without much fuss or muss, the price of Italian 10-year bonds has climbed on the secondary market and has hovered around 7% since mid-December. Spanish bonds are now on the rise again – having fallen from 6% to 5%, they are now back at 5.43% and climbing on the news of much higher than expected deficits and poor macroeconomic performance.This is bad timing. Between now and April, Spain has to refinance €55 billion (1) in maturing bonds while Italy must roll-over almost €160 billion (1) in the same period. It will be bad enough if Italy is forced to pay 7% on so large a portion of her debt, but it will be even worse if Italy is unable to find buyers in one of the big issues. These start in February. Then either the ECB does a 180º and rescues Italy or the “men in black” of the IMF step in. The third alternative – default – is not likely; not yet anyway. But the repercussions of an Italian rescue would be devastating.France is not immune either. The Fifth Republic needs to issue €140 billion (1) in new debt between now and April, and in fact, held an auction today. France sold €8 billion in 10 year bonds with adequate coverage (total bids equaled €15 billion). Due to the threat to her AAA credit rating, the French Treasury had to pay 3.28%. (2) The euro dropped below $1.30 in reaction to the news, a 15 month low, and could fall lower still. (3)
The first of the EU26 monthly summits is due in late January. I think markets have largely discounted the impact these meetings are likely to have, so there is precious little upside. However, there is potential downside, should one of these meetings blow up – with a “backbenchers’ revolt” of the smaller markets, for example. Even if the Barnum & Bailey is kept to a minimum, investors might despair at solutions that are years off, of dubious legal and constitutional validity and depend on unrealistic assumptions of growth or tolerance for austerity;
- Rating Agencies.The year ended with Moody’s, S&P and Fitch all either issuing warnings of imminent downgrades to AAA-rated nations (France) or else actually downgrading large swaths of European companies, mainly banks.Both Fitch and S&P have announced reviews of France’s AAA rating for the first quarter of the year, most probably sooner rather than later. Given that the economic and fiscal situation faced by France remains unchanged or worse than in Q4 2011; and given that the agencies do not believe the so-called “fiscal union” pact is in fact going to save the euro, it is probable that France will lose her perfect rating in at least one, and most probably all three of the main agencies.This would have important consequences for Europe, beyond provoking apoplectic reactions from French leaders. For one thing, it could cripple the European Financial Stability Mechanism at its inception and also hurt the already operating EFSF. This is because both organizations depend on the financial stability of the participating donors in order to issue their own AAA rated debit. France, being the second largest contributor, might have sufficient weight to swing the balance of the whole EFSF mechanism. Who then will rescue the rescuers?Additionally, French sovereign debt serves as collateral for many (mostly French) banks. Should this collateral suddenly become riskier, and worth less than it was, the holding banks would have to take a loss as well as make up the difference with fresh capital. French banks are not in the healthiest of states now. Such a blow could set off a chain reaction involving first one bank failure, and cascading into a run on the French banking system.Politically, a French downgrade would spell the end of Nicolas Sarkozy. The man in charge is going to get the blame, however much he may want to pass it off as a “nefarious Anglo-Saxon” conspiracy, and there are elections in France this year. Anyone who comes after Sarkozy will not only have to deal with a difficult situation at home, but will have to rebuild ties and trust with Angela Merkel. This at a time when Europe needs the Paris-Berlin axis to be in top form while the “fiscal union” project is underway. What’s worse, it could open the door to a shock victory by the ultranationalist Marine Le Pen. Le Pen has stated that she would take France out of the euro, “protect” French industry, and restrict immigration to France, particularly from Muslim countries. (4) The only thing lacking is a claim to the Sudetenland and a silly moustache for the picture to be complete.
If 2011 was the year that Greece and Italy were hammered, I predict that 2012 will be France’s turn. Hang on to your hats.
- Unpredictable Shocks.Natural disasters, wars, epidemic disease or market events could tip a destabilized world towards catastrophe. Precisely because they are unpredictable, there is no way to be adequately prepared for or forecast these events. Yet we can make some educated guesses.The most dangerous flashpoints are not all that unpredictable, in fact: Iran (& Syria), North Korea, the Taiwan Strait – these are the perennial sources of instability in the international system. Of these, Iran/Syria is likely to prove the most immediately destabilizing. The situation in the Islamic Republic is critical. The recent saber-rattling in the Straits of Hormuz were a sideshow and oil didn’t move a hair. But that could change very quickly. More critical is the continuing progress in Iran’s nuclear capabilities. France is pushing for stronger sanctions in the EU, while the US has already tightened the noose. While the non-adherence of Russia and China means that Iran is not truly isolated, the sanctions hurt nonetheless.The real threat to Iranian stability comes from Syria. Damascus is a key Iranian ally, and Hezbollah is Iran’s most important client as well as one of her most effective means of power projection. The Iranians view Western attempts to destabilize Bashar al-Assad’s regime as an indirect approach against Iran – which it is. The Israelis are more ambivalent: they prefer a murderous Assad to the uncertainty that may come after him. They don’t want Syria taken over by a doctrinally hostile religious party as Egypt threatens to be.
It remains unlikely that the West will mount another Libya-style campaign against Syria. The best placed power, Turkey, will not want to kill fellow Moslems without enormously greater provocation on the part of Assad. France and Britain don’t have the money to intervene and the US lacks the appetite for another “go it alone” adventure, especially in an election year.Nevertheless, expect the situation in the “Fertile Crescent” to deteriorate further throughout the year. If they do, even without a hot war breaking out, the price of oil could rise very significantly, putting further pressure on already weak GDP growth in industrial nations.
If we put all this together, it is easy enough to say that 2012 will be worse than 2011. But how much worse? Common Sense is going to go out on a limb and make some predictions:
- No Eurozone collapse. The euro will be buffeted and continue to slide against the dollar, but just enough will be done to prevent a collapse – in 2012;
- France will be downgraded. This will be one of the major blows to the euro early in the year, and will lead to a further shift of power to Berlin. Austerity and “fiscal union” will be the only solutions offered, thus deepening the recession in Europe;
- Sarkozy will lose the elections and the Socialists will come to power. The Socialist candidate, François Hollande, has promised to “renegotiate” the terms of the fiscal union compact of 9 December. He will be disillusioned by Frau Kanzlerin Merkel and will have to toe the line. France is no longer in a position to “go it alone” á là the United Kingdom. If Le Pen wins a shocker, all bets are off;
- Speaking of which, the UK is not about to fall out of Europe. David Cameron will continue to attend EU meetings and the UK will continue to influence the direction Europe takes. France won’t like it, but will not be in a position to block it; while Germany will welcome having the UK to balance out the peripherals – so long as Cameron doesn’t attempt to further disrupt the fiscal union pact;
- There will be no major bank runs in Europe as the ECB is making liquidity available as if money were water. That said, European banks will remain vulnerable to financial shocks and will spend 2012 recapitalizing themselves. Therefore, the credit crunch for businesses and consumers will not benefit in the slightest from the ECB’s largesse;
- Italy will begin to destabilize as austerity bites the social fabric and expect Silvio Berlusconi to begin positioning himself for a challenge to Monti. He is lurking in the wings as it is, but so long as Italy doesn’t suffer a bank failure or investor flight from her bond sales, he will not move in 2012 – but expect him to do so in 2013 if Italy remains economically stagnant;
- Bashar al-Assad will fall and Syria will degenerate into chaos. Hezbollah will move openly to become a “state-within-a-state” in Lebanon, and the situation in Syria will require months to play out. Luckily, this serves as sufficient distraction for both the US, Israel and Iran so as to avoid a war in the Persian Gulf in 2012. Besides, a war with Iran would be disastrous for the Democrats in the 2012 Election – I would not expect the US to start one (though the Israelis just might, for that very reason);
- Mitt Romney will win the Republican nomination for President. If unemployment is at or below 8% and if the economy has grown by an annualized rate of 2.5% or more by November 2nd, I believe Obama will be reelected. Not otherwise. Both candidates will be opposed by the radical fringes of their parties; this should favor Obama, especially as any maverick candidate (e.g. Ross Perot) would most likely be a disgruntled ultra conservative and draw votes from Romney.
(1) Bloomberg, as of 25 November 2011
(2) “Euro Falls As Debt Fears Resurface”, Huffington Post, 05 January 2012
(3) “French Bonds: 10-Year Yield Climbs, Demand Firm”, Reuters, 05 January 2012
(4) Gordts, Eline, “Marine Le Pen, France Far-Right Presidential Candidate, Advocates Euro Exit”, Huffington Post, 19 November 2011