Outlook for 2012
Lance Spicer, Editor - Trident Confidential, 25 Jan, 11:53 AM
Well, here we are ready to start a New Year and I hope your holiday season and New Year celebrations were fabulous.
Last year in my outlook, I said that I felt the US economy would strengthen and that there would be no double dip recession. I also said that the US market would outperform the Australian market, despite the “mining boom”, and we now know what happened. I just didn’t realise how right I would be, with the ASX having a terrible year, second only to 2008 in recent times. What I didn’t predict was the seriousness of the EU debt crisis and though I did predict an Australian recession, luckily I was wrong and we only had one quarter of negative growth, not the two necessary to be actually called a recession.
Of course, nobody could have predicted the war in Libya that upset oil prices and slowed growth, or the devastating tsunami in Japan and the floods in Thailand that have temporarily made a mess of many of our technology stocks. 2011 is certainly not a year I want to repeat and as most fund managers and investors will tell you, it was more difficult to navigate than 2008 due to its extreme volatility, often in both directions and with counterproductive currency swings. An estimated 87% of fund managers lagged the market due to this volatility.
However, we must look ahead and try to get an idea of what 2012 might bring. I have spent much of my break reading the thoughts of analysts, economists, commentators and fund managers and I have to tell you sentiment is mixed, ranging from a replay of 2011, to the start of a multi-year bull market. The sentiment of most retail investors is pretty appalling with the majority feeling that being out of the market is safest. I have never seen so many people negative about the markets – just about everyone I talk to (excluding investment professionals) is gloomy about the stock market – and justifiably so. But as you well know, the crowd is often wrong and when things are at their gloomiest (sentiment wise) things often turn. However, before that can happen there has to be justifiable reason for it to do so.
So, let’s consider all the risks we may face going into 2012. The number one issue is the European Debt Crisis. Firstly, the debt these countries have accumulated is high. It has taken years to accumulate and it will take years for the debt to reduce to manageable levels, we know that. We also know that for the next 1 or 2 years, European growth will be slower than the long-term average with possibly a shallow recession at the start of 2012. These are known factors. The fears are that it could get worse. That’s what is holding back the markets right now. It is the same fear that held back markets after the Lehmann Brothers crash in 2008. As we know, Lehmann was it and a few months later the markets recovered.
I expect the write off of Greek debt was the big event and while I still think that maybe another bailout of Greece is possible (probable?) in the near future, I don’t think there will be any contagion to other countries, with the slight chance of Portugal needing some assistance from the IMF and the ESM (the EU bailout fund), but this is only a slight chance. Greece and Portugal do not worry the markets - they are too small. It’s Spain and Italy that worries the markets and I think, as many do, that this fear is totally overblown. The secondary “concerns” are a slowing of China and the US economy, but these fears are also “overdone”, as there is more evidence supporting improvement than otherwise, particularly in relation to the US economy.
So, let’s get to it and see how I see the year panning out.
· US Economy
Most people declared the US would fall into recession in 2011, I did not agree with that at all, even though at times I seemed like the only person that had my point of view. I stuck to my guns and at times wondered whether I was reading different data to everyone else. It turned out they had been “bamboozled” by sentiment and emotion and there was no recession – not even close.
In 2012, my prediction is the same - No US recession and growth higher than many expect, edging close to 3% over the year (I expect global growth at an over trend rate of 4%, which is inline with the IMF expectations). Housing will stabilise and start showing signs of growth, but nothing to get excited about - just not worse. Unemployment will continue its current trend and by year-end will be under 8% - possibly well under. US corporate profits will continue to rise to new all-time record highs.
There is some speculation that US corporate profits will be harmed by any EU recession. The facts is US exports to the Europe amount to an estimated $240b for 2012. Of this 40% relates to aerospace and motor vehicles, 25% to chemicals, food additives and fertilisers, 20% to manufactured goods and technology and the other 15% made up of miscellaneous goods and services. A recession in Europe may cut this figure by say, 7% to 8% for around half the year. At which point the other half of the year, would probably show imports over trend, leaving the net exports situation down maybe 6%. On the basis the first two categories are unlikely to feel much reduction due to long order lead times, and the fact that chemicals, food and fertilisers don’t suffer in even bad recessions, there is limited damage that can be felt from Europe in terms of earnings. The GDP of the US is 14 Trillion, which is 14,000 Billion, so this puts the EU exports in perspective keeping mind the net fall may be around $14B, one thousandth of the US economy. However, this does not factor in negative sentiment that any EU recession may cause domestically in the US, which could be more wide-ranging or strains on US banks who provide significant loans to EU business.
IT (Information Technology) spending in the US alone is tipped to rise to $1.8 Trillion (not a typo) according to a survey by Nucleus Research. This is a substantial increase over 2011. They found that over 50% of US companies plan to increase their IT spending to higher levels than 2011. Only 10% said their spend would be lower.
“We are bullish on tech spending based on these survey results. While there is a temptation to cut IT budgets right now, our survey shows that companies view technology investments as a means to drive efficiencies and make existing employees more productive,” said Rebecca Wettemann, VP of research, Nucleus Research.
Another survey determined that over 50% of medium to small companies were planning large scale IT investment in the first half of 2012. These surveys covered thousands of US corporations from huge to small, so it’s not a skewed result at all. It’s also backed up by what I’m hearing from CEOs in IT companies and their growth plans for 2012. It looks like 2012 could be the biggest IT spending year in history by a long shot. The surveys uncovered that the biggest sectors for investment were mobile communications, data storage and security, social networking, analytics, and corporate efficiency. Every technology company we hold is sitting in the box seat.
There is a mountain of evidence that by the end of 2012, the US economy will again be the leading light in the world economy. I also expect a big “come back” by US financial institutions in the second half of the year as lending frees up further and US home sales increase with higher consumer confidence. Boring old industrials will also start to come back as US manufacturing continues to gain strength. However, it will be the technology companies like Apple, Intel and the like that will be the “stars” of 2012.
· European Debt Crisis
One trader on the floor of the US stock exchange said just after Christmas that he thought the market would be “out of the gate in 2012” when we all got tired of hearing about Europe. He said it happened in relation to Japan and Libya and it will happen with Europe too. I agree. Once we see that the Euro won’t fall over and no major bailouts are necessary, the whole thing will fade.
The ECB has injected hundreds of billions of Euros (E600B) into the banking system at 1% interest to increase liquidity and give EU banks an opportunity to strengthen their balance sheets and they have taken up the offer with both arms. The first thing they did was use 50% of the money to pay off their short-term debts (3 to 6 months) to the ECB thus turning higher-interest, short-term loans into 1% 3 year loans. This will increase their lending capacity and profits. It’s expected the rest of the money will be put to use being lent out into the retail market and to also (as I predicted last year) buy bonds, such as Italian and Spanish bonds at much higher yields and again make money and repair balance sheets through this “structured and arranged carry trade”. While the ECB couldn’t provide Quantitative Easing, they could arrange for the banks to do it for them.
Once the bailout fund, the ESM, is fully operational and funded to the required level, it will then provide the banking system with the assurance that any further sovereign debt problems will be met by the IMF and the ESM and not be worn by the banks, as they did when Greek debt was cut in half. While it seem the EU banks are getting profits on a platter, I suspect it was part of the deal when they all agreed to accept the Greek “haircut” and quite frankly, Europe needed QE and this was the only legal way of doing it without the “argy bargy” of getting all EU members to agree to a treaty change in relation to the ECB.
So, I think after the first quarter of 2012, the European Debt Crisis will fade as bond yields slide in the wake of the “EU carry trade”. One problem that still needs to be addressed however, is in relation to Italian bonds, in particular 10-year bonds that will mature in the first quarter of 2012. The bond yields as at the end of 2011 were stubbornly stuck around the 7% level, yet shorter-term bonds, up to 3 years were trading at between 3% and 5%. The reason? The 1% ECB loans to banks are 3-year loans and they are being used to purchase similar aged sovereign bonds, bringing down the shorter term yields. If the ECB wants the 10-year Italian bond yields to fall, they need to make some 10-year loans available at favourable rates for this purpose or step in themselves and buy the longer term bonds.
We will still hear of problems in Portugal and Greece and possibly Ireland, but as the problem will be contained to these countries most investors will simply “move on”. These countries, despite having what may be devastating recessions, will have little to no effect on the US corporations. Growth in “Northern Europe” will be surprisingly strong. However, not so strong, that I would be compelled to invest there, just yet.
· China
China will continue to grow strongly in 2012, but not without a couple of minor scares. The property boom in China is heading for a “hardish” landing but not a crash - the Chinese would never allow a crash of any kind. The banks who had lent so prolifically will pull back their property lending even more than they already have and this will have a negative effect on growth. I expect Chinese growth to pull back to around 7.5% to 8%. This is a drop of around 1% from many forecasts. There will also be some slower growth in manufacturing due to their single biggest market, the EU, slowing. Although many Chinese goods are at the “lower end” of the market and will be less affected than the “mid-range” goods that will be subjected to household budget constraint. The “upper end” won’t be touched at all – it rarely is.
This will have some effect on commodities (and Australia) but not devastatingly so. The Chinese middle class will continue to grow and consumerism will flourish and this will benefit companies like Apple greatly where US branded goods are seen a status symbols. Don’t underestimate the importance of status symbols in Chinese culture and how they perceive the value of things we take for granted. While our desire for the latest iPhone or iPad is high, theirs is out of control and keep in mind there are more middle class Chinese than there are Americans, Canadians and Australians combined.
· Gold and Commodities
Gold and commodities won’t collapse in 2012, nor will they boom either. We may have seen the near-term peak in gold. Gold is a hedge for worrying times and also a hedge for inflation. Worries and inflation are dissipating and so is the price of gold. As the market improves throughout 2012, you will see gold soften a little further. The gold price is still being supported by the Indians and Chinese however. They love the stuff and as they become wealthier, their desire to hold gold (as a status symbol) grows. These two countries alone will keep the price of gold above $1200-$1300 for the medium term.
As regards other commodities we have several forces at work here. We have increased production from Australia, Africa, Asia and the Americas keeping a lid on price increases. On the flipside we have continued expansion of emerging nations requiring ever-greater quantities to continue development. On the downside we have the EU being a temporary drag, as well as western governments around the world having to think long and hard about their budgets and which infrastructure projects to commit to. On the upside we have the US economy starting to strengthen and use more commodities. At the end of the day, weighing it all up, don’t expect commodity prices to shoot up in 2012, with the possible exception of copper, which has dropped more than it should have. Commodities will remain pretty much in equilibrium.
Oil will remain elevated due to tensions with Iran. If these tensions ease expect oil at $80-$90, if not they‘ll stay around the $100 mark for most of the year. This level of oil price won’t be too much of a drag on economies, but any move above $110 will cause consumer confidence issues in the US. Let’s hope the Iranians can remain calm (and “sane”)
· Australian Economy
First the good news, there will be no recession in Australia in 2012 (not a bad one anyway). The mining “boom” will continue to support virtually the whole economy, but things won’t be quite as rosy as we might hope. The lack of rising commodity prices will keep a lid on some projects and investment may fall a little short as “borderline” mining investment may be shelved due to not only flat commodity prices but also due to government created uncertainty with the Mining Rent Tax, Carbon Tax and anti-business industrial relations policies as well as hard-line Green anti-mining interjections.
We will, however, have further interest rate cuts as consumer spending shrinks further due to lack of business and consumer confidence. This may pick up a little early in the year as the EU debt crisis exits the headlines. However, it will be the introduction of the Carbon Tax that will be on the minds of most Australians and just like when the GST was introduced, we stopped spending for a while, however, it soon returned to normal, as it will in 2013 with the Carbon Tax. I think it will affect household budgets more than the government is letting on and it will have an even worse effect on business, which could see growth in Australia fall to around 2%-3% instead of the expected 4%. The really bad news will come in 2015 when, even the “compensated” will be affected by the removal of Carbon Tax industry subsidies, which will allow the full affect of the tax to flow through to us all, but that is 3 years away yet.
To be honest, outside of mining and mining services, there are few Australian companies that have solid earnings growth catalysts. We have very little technology, almost no manufacturing, a few companies involved in healthcare and quite a number involved in financial services such as insurance and banks. Take the banks as an example - where are catalysts for earnings growth? Housing is struggling and interest rates are dropping, squeezing margins as they are bullied into passing on the full RBA cuts. The banks aren’t lying - passing on the full cut means a drop in rate margin profit for them. Usually, a rate cut means more loans being taken up - meaning they cut margins but increase volume, but that’s just not happening, as Australians are still de-leveraging debt. The banks can only profit by sacking people, raising fees and utilising ever greater levels of technology – all of which they are doing to keep earnings momentum going, albeit at a reduced pace. Companies right round the world are using technology to reduce staff. The banks are no different and this remains part of our investment strategy to invest in technology, rather than the users of technology - following the “picks and shovels” concept. Elsewhere, I see opportunities within the smaller cap sector, where innovation may drive earnings, so keeping a lookout there may provide some opportunity.
Overall, despite Canberra pointing out how well we are doing, most Australians just can’t see it and don’t believe it. I think we will look back at the mining boom and feel it was wasted, due to a government that struggled to balance socialist ideology against capitalist opportunity and the best they could come up with was two new taxes and restrictive and anti-business work practices that appear to be a knee-jerk over-reaction to the former government’s policies. No regard was, or is given to “nation building” through productivity gains, workplace reform, industry assistance, government regulation and “red-tape” reduction, innovation or widening the “economic base” beyond hard and soft commodities. For this reason, I feel the Australian economy will be in a slightly worse condition a year from now. In much the same way President Obama missed an opportunity to be a champion of reform and recovery, the Gillard government has missed an opportunity to build on Australia’s good fortune of having China as our major trading partner. With such favourable trading terms, exports at record levels, we are still running trade and budget deficits – when will Australia ever run a surplus one must ask? Which brings me to debt - as trade deficits as well as budget deficits are funded by debt, most of it foreign. We have accumulated $848 billion in debt (and rising), which represents 60% of GDP. This is a figure the government keeps a lid on. Most Australians don’t realise we are right up there with the UK, Spain and Germany when it comes to debt load. Our bureaucrats just account for it in a different way so it doesn’t seem so bad, but it exists and it’s growing. Things aren’t as rosy as Mr Swan and Ms Gillard would have us believe.
Over the coming year we should see the Australian dollar weaken further, as not only will our terms of trade weaken, but also the carry trade related to our higher relative interest rates should see investors exit Australian dollars to some extent. I expect to see the Australian dollar finish 2012 at around the $0.96-$1.00 range. Although, according to the IMF the Australian dollar should be around $0.66-$0.70 range to be correctly valued. The continued strong demand for Australian commodities will keep the AUD$ elevated through the first half of 2012, maintaining some of the current pressure felt by domestic retailers, exporters and tourism and hospitality operators. The second half of 2012 should see weaker commodity prices, a weaker AUD$ to compensate to a degree, but lower earnings growth. It may be time prepare for the Post-Mining Boom period, when mining no longer provides the growth the Australian economy has become so used to.
However, while I remain a little bearish on the Australian economy, there will still be plenty of opportunities to profit and there is a chance that above expectation growth in the US and China might just save us from what could be a mediocre year.
· The Markets
The first quarter may feel a little like a continuation of 2011, as the possible solutions to the EU debt crisis are muddled through. However, I think by the end of the first quarter fears of a complete meltdown will have disappeared and concerns over China and the US will be to a great extent placated. This should see steady gains through the second quarter as investors return to equities.
There are a number of factors pointing to 2012 being a stronger year for equities:
1. US corporate earnings will again further increase the record earnings level. This will further compress PE ratios to historically low levels. Currently, forward PE ratios (for the total US market) are at 12, whereas for several decades the level has been between 15 and 16. This indicates that equities could be 40% undervalued - a statistic that doesn’t remain out of kilter for too long once near-term fears ease.
2. The S&P 500 valuation is at a current PE ratio of 13.3, this is exactly the same PE and market valuation the market reached in March 2009, before that amazing rally into 2010.
3. In 2011, S&P 500 profits reached a record $97 per share, which based on the long-term average PE ratio of 15.5 should have seen the S&P 500 achieve a year-end of around 1503 – it finished at 1260, about 20% undervalued. Next year, the estimate for S&P 500 profits is around $105 depending who you listen to. Goldman Sachs are the most bearish and they say $100. So based on the consensus (and they were too low last year) the S&P 500 should finish 2012 around 1650 to be fairly valued. That’s a 31% lift from here – unlikely, yes I know, but what is far more unlikely is a fall from current levels.
4. Rarely does the dividend yield on the S&P 500 exceed the 10-year US Treasury bond yield as it does now. Whenever this has occurred, there has been a violent snap back by equities in the near-term.
5. Since the 1960’s the Dow Jones Industrial Average has reacted inversely to the Initial Jobless claims issued by the US Department of Labor weekly. The steady trend downwards in jobless claims would indicate that a significant rally on the Dow was overdue.
6. Economic fundamentals in the US continue to improve monthly. In addition, consumer and business confidence is approaching pre-GFC levels.
7. US home sales and housing starts have shown signs of recovery and many US homebuilders expect to increase employment in 2012, thus further reducing unemployment concerns.
8. The US are reducing their involvement in foreign wars with the withdrawal from Iraq. This will be beneficial to the US economy, as they have already spent over $1 Trillion dollars on Iraq. History has shown, since the First World War that the US stock market goes sideways during times of large-scale war and then heads steadily up in times of peace. The current sideways movement began with the War on Terror. The last time the US market had such a long-term “sideways” movement was during the Vietnam War (1965 to 1975).
9. Periods of low interest rates are normally associated with bull markets due lower returns being offered by non-equity investments. With lower interest rates around the world being with us for at least another 18 months to 2 years, we can expect once fears ease that equities will offer the best returns.
10. As pointed out earlier, technology spending in 2012 is set to be the highest in history.
11. I would like to add to the list the predictions of hedge fund legend Doug Kass, who last year picked the market almost precisely, as he often does (although, he did get the price of gold wrong and he missed on Microsoft taking over Yahoo), but everything else was very close. Whilst I completed my analysis and had written this report before his ideas were available, I thought you might like to see what his major predictions for 2012 are:
· For the US market to hit an all-time high August or September.
· Growth in the US economy to accelerate
· Mitt Romney to defeat Barack Obama in the presidential elections
· There to be a brief scare over the EU debt crisis in early 2012 due to Greece running off the rails with riots and the Greek PM weakening on austerity. He is quickly brought back into line.
· The EU suffers a very mild recession and the ECB continues to flood the market with cheap money. The EU recovers rapidly.
· German and French stock markets rally strongly.
· Apple’s share price to hit $550 and introduces a dividend. iPads and iPhones completely dominate their rivals.
· We’ll see merger mania fuelling markets
· Financial stocks to make a big comeback
· Retail investors’ flock back to the market – Mutual funds have the best year since 2007.
· China has a soft landing
· Israel attacks Iran – The US stays out of it and tries to broker peace.
Now, these are the predictions of Doug Kass, who has a very good record at being very close to the mark every year. However, I must say I agree with much of what he’s predicted.
So, what could undo a rally in 2012?
Simply something not on the current horizon – known as a black swan event e.g. a war with North Korea or Iran for example or possibly an earthquake in a major city in Asia or the US – something along those lines. A black swan event could happen at any time and you shouldn’t base your investment strategy on something that may or may not happen.
The only known concern that could cause trouble would be an unwinding of the EU and a breakdown of the Euro.
However, if that was going to happen, it would have happened by now, as many steps have already been taken that have eased that possibility, such as: Strengthening the banking system with injections of cheap money by the ECB; Strengthening the fiscal responsibility and accountability of member countries for future budgets unanimously; Also strengthening and increasing the size of emergency bailout funds and instigating a process whereby central banks around the world co-operate in providing liquidity, such as the process of reducing the margins charged on US$ loans. Lastly, it’s in Germany’s (and Frances’s) best interest to keep the Euro and all the countries (except maybe Greece) in the Eurozone, and quite frankly they have enough economic might and reserves to ensure that it remains workable.
Potential sovereign downgrades by ratings agencies will have a very short-term effect on markets, as we saw when the US was downgraded, but then recovered in literally weeks. I expect any EU downgrades to have an equal or lesser effect.
Conclusion
The weight of economic evidence points towards much higher equity markets in 2012, in particular the US and Germany. Australia will rise to a lesser degree on the back of the US market.
The only major risks seem to relate almost exclusively to a very unlikely unravelling of Europe, which as each day passes looks less likely. It seems we are in a fortunate position right now, fear and concern is still very high keeping markets low, yet fundamentals are telling a very different story. Often opportunity comes wrapped in a problem, 2012 could be a year to start unwrapping.
Our start to 2012 has been great - Trident Connfidential Portfolio is up 15% this year already.
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I wish you all the very best in your investing.
Regards,
Lance Spicer