The markets are, it seems, more susceptible than ever to macroeconomic events. Although corporate profits have been strong and cash reserves high, equity prices have been buffeted by developments beyond management control. We expect the volatility of recent years to continue through 2012. While we still do our fundamental analysis, here are some of the macro areas that we will be watching closely:
Europe, of course. Markets rally at the slightest hint of good news. The crisis there moves inexorably along, moving from peripheral countries into larger economies, threatening the banking system, the integrity of the euro and the European Union itself. Recession is expected, deep in some countries like Greece and mild in others like Germany. As difficulties mount, the political will to sacrifice for the benefit of a greater European good will be tested. We do not pretend to know what will happen; but, as events unfold, expect consequences beyond Europe’s borders. Eastern European countries, even Turkey, would be very vulnerable to worsening financial problems.
China is deliberately trying to slow down. In 2009, China’s stimulus program was the equivalent of 12% of GDP, an enormous amount. While it compensated for the loss of spending by US consumers during the recession, the revival expressed itself in a property bubble and inflation. Rising food prices are a concern to a government worried about political unrest. As inflation slows and as certain sectors of the economy (export and real estate) struggle, we think the country will revert again to stimulus measures to keep growth above 8%. Auto sales, while expanding, are coming in well below the forecast of 10% to 15% growth by the China Association of Automobile Manufacturers. Auto sales grew 32% in 2010 in response to subsidies that were part of the 2009 stimulus. The government continues to squeeze the private residential construction sector, hoping that public housing projects will counteract the slump in the private sector. While it wants to slow down, China will do what it can to maintain growth at 8%, the minimum required to sustain current employment levels. On November 30, China’s central bank reduced bank reserve requirements to 0.5%. It is likely that renmimbi revaluations will slow, too. China probably has enough margin to keep this act going until it transitions to new leadership toward the end of 2012. However, imbalances in China’s economy will prove difficult to manage. Should growth go below 8%, natural resource based economies, such as Australia, Brazil and Canada, will be affected.
While we have been encouraged that the US consumer has been deleveraging, we were disappointed to learn from Gary Shilling, the renowned economist, that of the $672.2 billion decline in mortgage debt from the debt ratio peak in the second quarter of 2008, $626.8 billion in mortgage debt was written off, meaning home owners reduced their mortgage debt through repayments by only $45.4 billion. While it is a good thing that banks and nonbanks are realizing loan losses and debt burdens are being reduced, we will be looking closely at residential real estate. Further declines in housing prices would jeopardize fragile consumer spending, currently supported by reaching into savings.
We have been reluctant to focus on the Middle East, where the potential for really bad news is ever present. Although oil demand will decline with slowing global growth, we maintain an above market weight in the energy sector as a precaution of further destabilization in the Middle East.
Our base case for the US economy is for continued slow growth, not recession. However, growth of only 1.5% makes the economy vulnerable to any exogenous event. It behooves us to be vigilant, particularly in light of the disproportionate effect these events can have on market volatility.