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Oh joy! It looks like the first half of 2012 will be a continuation of the last half of 2011--here's how to navigate the uncertainty
12/13/2011 8:30 am EST
Why? The global economic picture looks very unfriendly to financial markets in the first six months of the year.
Not so much because the forecast for growth is so bad. In early December economists surveyed by the Philadelphia Federal Reserve Bank projected that the U.S. economy would grow by 2.1% in the first half of 2012. That’s a long way away from a recession even if it’s not the magnitude of growth that would cut quickly into the current high unemployment rate. Barclays is projecting that growth in China will slow to an annual rate of 7.8% in the first quarter of 2012, the quarter the investment bank is forecasting as the slowest of 2012. And even in the EuroZone, the origin of the current global economic slowdown, the Organization for Economic Cooperation and Development forecasts that growth will turn negative in the first part of 2012 but the end-of-November prediction of a 0.4% contraction in the first quarter of the year would still amount to just a mild recession.
Not the best of times certainly but not exactly a replay of 2008 either. So why am I very worried?
Because stock market history argues that the correlation between the magnitude of economic growth and stock prices is actually not all that strong. What’s more important is the direction of change in rates of economic growth and the degree of uncertainty about future growth rates. On both those two measures—direction of change and uncertainty—the first half of 2012 scores as a very worrying period.
Let me start with China to show you what I mean. Growth in China is key to demand for global commodities such as iron ore, copper, coal, and oil and for demand for goods and services that range from Coach (COH) bags to Maxwell Technologies’ (MXWL) ultracapacitors to Ctrip.com (CTRP) travel bookings and HSBC (HBC) investment banking services.
So what will the growth rate for China’s economy be in 2012?
Even looking at a fairly optimistic forecast like that from Barclays the direction of the trend isn’t comforting. Barclays is calling for growth in the Chinese economy to slow from an annual rate of 9.1% in the third quarter of 2011 to 8.3% in the fourth quarter of 2011 to 7.8% in the first quarter of 2012.
And the conviction in any call on China’s growth rate is fairly low. Or to look at it the other way around the uncertainty is fairy high.
I have a sense that any of these projections is only provisional and that analysts are still rushing to play catch up with events. Barclays has cut its forecast for all of 2012 to 8.1% from 8.4%. Morgan Stanley has cut its China forecast to 8.4% from 8.9%. But you don’t have to look far to find more bearish forecasts.
And even those provisional forecasts are coming with more caveats. The Morgan Stanley forecast, for example, is for a most likely scenario resulting in 8.4% growth but a bearish scenario resulting in a drop to 7.7% growth for 2012.
The uncertainty in forecasts for China or the United States or the global economy as a whole largely stems from uncertainty over depth of the slowdown in the EuroZone. The lower the growth in the EuroZone the lower growth is likely to be in the countries that trade with that group.
The European Central Bank captured that high uncertainty in its forecast for 2012 growth issued by its economists last Thursday, December 8. The bank said that for 2012 growth in the EuroZone would fall between 1%--weak growth—and a negative 0.4%--a mild recession.
Compare that to the last forecast from the bank’s economists that looked for growth of somewhere between 2.2% for 2012 and 0.4%. On the numbers, you could say that the degree of uncertainty is lower in the latest call—the difference between the high and low ends of the forecasts has diminished to a 1.4 percentage point spread from the prior 1.8 percentage point spread. But I’d argue that from an investor’s point of view the uncertainty has actually increased since now the difference between high and low forecasts is the difference between mild growth and mild recession instead of between solid growth and mild growth.
With the trend pointing downward, investors can be forgiven for thinking that the next set of forecasts won’t show a median of 0.3% growth for 2012 but a solidly negative forecast for the year.
And the recently announced grand plan to save the euro (is it Grand Plan #3 or #4? I’ve lost count) concentrates the risk in the first half of 2012. Even if you take European leaders’ time table as accurate (I wouldn’t but you can if you like), the permanent European Stabilization Mechanism, with its 500 billion euros in bailout funding, isn’t set to go into operation until July. Nobody knows how long it will take the International Monetary Fund to get its 200 billion in new funding into position—and nobody knows exactly what the IMF will do with that funding in support of Eurozone bond markets and EuroZone governments.
What we do know is that the first quarter is loaded with funding needs. The Royal Bank of Scotland calculates that EuroZone governments will need to sell 824 billion euro in debt in 2012 and that 225 billion of that will need to be raised in the first quarter of 2012. That’s not the end of the EuroZone’s calls on the financial markets either. Agencies and supranational bodies such as the temporary European Financial Stability Facility—the bailout fund that is now selling bonds to support Greece, Ireland, and Portugal—will have to issue 175 billion euros in debt in the first quarter. As much as 45 billion of that is needed for Ireland, Portugal, and Greece.
Think any of this will be an easy sell in early 2012?
Especially not if, as many European constitutional experts now worry, the plan to fix the long-term problems of the euro through a new treaty with somewhere between 17 and 26 signatories turns out to face a legal challenge. It’s not clear that a group that is not the European Union—and since the United Kingdom has rejected this approach the proposed new treaty won’t include all members of the European Union—can utilize European Union bodies such as the European Commission and the European Court of Justice to enforce the budget mechanisms envisioned in the planned treaty backed with such fervor by Chancellor Angela Merkel of Germany. At the least these doubts will hang over the treaty effort as it slowly advances through summit meeting after summit meeting.
And it’s not as if the EuroZone is the only source of uncertainty for the first half of 2012. In the United States it increasingly looks like Congressional gridlock will allow even the modest stimulus of the reductions in the Social Security withholding tax to expire at the end of the year. Goldman Sachs estimates that letting all the Lame Duck stimulus programs expire at the end of 2011 would result in a 1.5 percentage point drag on growth in early 2012. In other words that relatively modest 2.1% growth forecast for 2012 could turn out to be much, much more modest.
China and other emerging economies present their own uncertainties in the first half of 2012. As Brazil just demonstrated by announcing that GDP in the third quarter had declined from GDP in the second quarter, it is by no means certain that countries that were tightening monetary policy in the first half of 2011 to slow their economies will be able to reverse course quickly enough to prevent a greater than desired economic slowdown at the end of 2011 and into 2012.
I think the global economy will look very different by the mid-point of 2012. I don’t think growth will have necessarily turned around. The EuroZone’s insistence on austerity as the almost exclusive tool for fighting the euro debt crisis has locked that part of the global economy into a period of slow to no growth likely to extend beyond July 2012. Political gridlock in the United States isn’t likely to dissolve by July—when everybody is posturing for the November elections.
But I think by July 2012 investors will know a lot more about where the bottom is for growth in China, Brazil, the United States, and the EuroZone. Growth may not be particularly strong but the downward trend in growth will be less pronounced and the uncertainty will be dramatically reduced.
Just consider, for example, that we will know if inflation in China is, as now looks possible, reduced enough to allow the People’s Bank to cut interest rates. We’re even likely to have seen the first actual interest rate cut. We’ll know if the Banco Central do Brasil has cut rates strongly and quickly enough—I think it’s likely—to stop Brazil from sinking into recession. We’ll know more about how much spending the U.S. consumer can support without growing incomes—less than in November and December but still some, I’d project now. And we’ll know if the follow up meetings on the euro have actually resulted in a real plan or something that remains tarte tatin in the sky.
You invest in such a two-faced year by pursuing radically different investment strategies in each half of the year.
In the first half you concentrate on preserving capital. Raise some cash by reducing riskier positions in high beta stocks and markets. In individual sectors go for companies with stronger balance sheets, bigger cash flows, and stronger market positions—and sell your speculative stocks in these sectors. Concentrate on stocks that pay dividends since those cash payouts will support share prices as well as pay you while you wait.
I don’t think you need by any means to sell everything—keep the long-term picks that you feel most confident about--but the goal is to be sitting on a significant amount of cash so that you can put it to work when uncertainty has driven prices lower in May or June or July.
By taking that stance, you will move time to your side in two ways. Every decline in stock prices is a chance to buy in at a better price, and every drop in the market is just storing up energy for a rebound on a reversal of downward trends and a decrease in uncertainty around the middle of the year.
The stocks you’ll want to be buying then are in markets where the projections of growth trends have reversed—going from fears of the negative to hopes of the positive. To me at this point in time that looks like overweighting stocks in emerging markets such as Brazil and China.
I’m not looking for a huge market collapse in the first half of 2012. The model of the next six months might be the last six months of high volatility around a downward trend in share prices that has been felt most strongly by stocks at the center of the euro debt crisis and by stocks in markets where the economic trends have moved downward and produced big uncertainties. For 2011 to the close on December 10 the Standard & Poor’s 500 Stock Index is up 1.8%. At the center of the euro crisis the German DAX Index is down 14.6% for the year. And where uncertainty about economic trends has been highest in China Hong Kong’s Hang Seng Index is down 17.1% for 2011.
I think there’s a lesson there for 2012—and I’m looking for one of those numbers, that for China and Hong Kong in particular, to be very different by the end of 2012. All we have to do is get there with our portfolios intact.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Coach as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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