Otago Daily Times Managing Funds columnist Peter Smith is wondering what 2012 will have in store for investors. In the first part of a two-part series, he looks at the Europe and how the banks are reacting to a credit crunch.
What does 2012 have in store for us? It is the Chinese year of the dragon. Will it roar?
Probably not. I note that in my comments of December 29, 2010 I correctly predicted that low interest rates (less than 0.5%) in US would make their sharemarket the place to be; National would win the November election; New Zealand's economy would have a good injection towards year end with the Rugby World Cup; the All Blacks would win the cup, and, everything would be fine again.
I was not on target about the European situation stabilising, because the core countries such as Germany and France do not want failure. The mess has not improved because nobody will accept the pain required to make it work. China has eased back in expansion as it has problems at home (see below), and while emerging markets are still popular, they are not the smartest places to leave money when governments can just nationalise everything.
Nobody could have predicted the devastation of the Christchurch earthquake in February and the earthquake and the shocking devastation from the resulting tsunami in Japan in March. Most recently, floods in the Philippines and Nelson have caused considerable destruction. Recovery from these events will dominate 2012.
The rating agencies have been very busy in 2011 and will be even more active in 2012.
As a country's inability to repay increases, the people's productivity declines, then the country rating status is reduced by the rating agencies and they have to pay more at higher interest rates. Italy is the classic example, where two-year bond rates have been as high as 7%.
Compare this to the US where two-year bond rates are 0.26% and 10-year bond rates 1.9%. The US has ability to pay as it can manufacture more debt. Italy cannot manufacture debt under Euroland rules.
The health of distressed European nations and the remedies deemed necessary to rescue them will have little direct impact upon us, but it will impact on capital flows, currency volatility, interest rate spreads, investor confidence and global interest rates. The debt level of the five most vulnerable countries, Portugal, Ireland, Italy, Greece and Spain (known as the PIIGS) are huge.
Most comments are about Greece but its debt level, at $US236 billion is the smallest of the five. Italy's debt is $US1.4 trillion, Spain $US1.1 trillion, Ireland $US867 billion and Portugal $US286 billion. It is not so much their actual holdings that are the problem but the inter-party loans of each.
Should one fail, they will all go.
The American elections will be a distraction for the economy there in 2012. President Obama, at present, is likely to be re-elected - assuming he is still the Democrat candidate - as all the Republican nominations so far have not found a strong candidate. Unemployment is officially 8.6% in the US, having fallen slightly over 2011. The US housing market is still showing a high level of mortgagee sales, reflecting a structural problem that would take years to fix.
The Occupy Wall Street protest that started in September 2011 will continue in 2012 but the chances of it making a difference seem remote. They have just had some new fodder added according to the UK Guardian newspaper of 14 December 2011.
America's top bosses enjoyed pay hikes of between 27% and 40% last year, according to the latest survey of US CEO pay.
Three of 2011's top 10 earners come from the healthcare industry. Top earner John Hammergren, at McKesson, the world's largest healthcare firm, made $US145 million last year, most of it from stock options.
During the year four of the 10 highest-paid CEOs were retired or departing executives with payouts ranging from $US98 million to $US28 million, including a final annual salary.
The British Government has introduced legislation to make the banks split their investment arms from their everyday retail operations. It will be interesting to see how it works, with the reporting of their actual profits being more transparent.
As 2012 moves on, European banks have to comply with Basel III and need to raise capital.
They have been shrinking their balance sheets by selling their non-European debt around the world to local banks, taking liquidity out of the market in countries such as Australia. For example the French bank BNP Paribas, anticipating the downgrade of French government debt, is winding back its lending commitments all over the globe. In Australia, BNP has withdrawn from its participation in the $3.7 billion Victorian desalination plant and has also withdrawn its financing of $2.1 billion for the Sevenwest Media deal - the merger of Channel Seven and Western Australian Newspapers.
It is the smaller companies that will not be able to get bank financing in a credit depression.
Global trade between importers and exporters needs short-term credit from banks to thrive. If banks do not fund that trade, it will not happen. It is a vicious circle, as the current crisis is forcing banks to hold on to capital and liquidity, leading to the lending market drying up and making credit more expensive, leading to a recession.
The new regime in North Korea is going to be a dominant topic in 2012. China has been its biggest ally, but despite expanding all over the world in buying up resources, China does have problems at home. Just recently China set out to merge Yancoal Australia and Gloucester coal. This has caused some nervousness in Australia as they see China and Korea as a threat to their mineral resources, even to the hypothetical suggestion that maybe China-Korea might actually use force to get what they want.
In China the people that occupy the land do not necessarily have title to it. Local governments in China have made much money selling land to developers. They also use local land as collateral for loans to finance massive infrastructure projects. That whole phenomenon is now unravelling. At least 13,000 angry Chinese villagers in Wukan in Guangdong Province physically drove the police and the Communist Party out of the city. The underlying issue seems to be that party officials were stealing villagers' land in order to sell it into China's massive property bubble.
However, prices have fallen and those who have bought are now distraught, because in cities such as Shanghai and Beijing, prices are now 35% less and being discounted to mop up unsold apartments.
Any regime in charge of a nation state knows that the best way to distract unhappy people who have no jobs or have just suffered a loss to the wealth is to find a foreign enemy and build them up to be a threat. This is the fear about Korea.
Global growth is expected to be 1% in 2012, despite the turmoil. The key to survival in Europe is to get the Greeks to pay tax and the Italians to stop in-house fighting.
Most of the banks in Europe are only surviving by using liquidity derived from the European Central Bank (ECB) purchase of bonds. Just before Christmas, the ECB offered funds at 1%. This was snapped up but will only be held for liquidity, not lending. How they will repay these funds in time is the difficulty. China offered to help from behind the scenes for Greece, just as it did in assisting with the Ireland bail-out in late 2010, but the conditions were too tough for the ECB to accept.
If Europe has secured the delinquent countries as above, including Italy and Spain, no matter how unpleasant the fix ends up, while the core economies (Germany, France, Belgium and Netherlands) continue to post solid growth, confidence in the euro zone will strengthen again, along with the euro itself. A recent German poll gave a very positive spin to general economic confidence. If the emerging markets have persisted with efforts to contain inflation, confidence in the rebalancing of international trade flows will get more of the recognition that facts on the ground already warrant. This is bullish for equity markets but again, it is the Korean factor that will cause worries.
• Peter Smith is an authorised financial adviser and a certified financial planner and is the principal of Kepler Group Otago Limited, Dunedin. A disclosure statement is available on request and free of charge.
