EDRG: Market Outlook : 2012 on the same path as 2011?

After the doubts of summer / autumn 2010, the first months of 2011 saw renewed confidence in economic growth and equity markets.
This winter-long optimism quickly faded away as indicators deteriorated, and serious concerns over European developments took precedence.
Over the course of a few weeks, the tsunami in Japan and its impact on logistics and global production, the hike in oil prices and the European sovereign debt issues, followed by the US fi asco of budgetary negotiations, broke up the foundations of business confi dence. Less visibly, the cutbacks in US public spending (at federal and local level) contributed from Q1 to the slowdown. And fi nally, the American residential property market remained depressed, adding to the deterioration of household consumer confi dence.
Should one fear a similar run of events this year? While disasters such as the destruction and disruption caused by the earthquake and tsunami in March last year are naturally one-off events, how about the others?

HIKE IN OIL PRICES
The parallel that can be drawn between the first months of 2011 and those of 2012 is striking.
Last year, Libyan production and exports were deeply disrupted by military action and the Brent reached $127, before easing to $105-115.
This year, oil prices fi rst reacted to tension in the Strait of Hormuz and then to the potential military engagement between Israel and Iran.
The historically low stock, production difficulties in Nigeria, Yemen and Sudan all contributed to the hike, with the Brent reaching $128.
While oil surged to similar prices, the varying amplitude of each upward movement is crucial in economic terms. Compared to the 2000 average, oil had risen 50% in Q1 2011.
On the same basis, Q1 2012 prices are up by less than 10% compared to the 2011 average (approx. $110). Within the Euro zone, the rise is higher by 2 to 3 percentage points, refl ecting the weakening Euro against Dollar. By defi nition, a hike in the price of petroleum products is negative for a consumer country, but the pace of the rise determines the impact on the economy – particularly on consumer sentiment and confi dence. At this stage, higher oil prices have not prevented confi dence from recovering in the United States from its summer 2011 trough. Admittedly, the price of gas (25% of energy needs) has fallen 40% compared to its 2011 average – to the benefi t of companies but also households, albeit to a lesser extent.

While it is tricky to forecast the trend in oil prices for the year to come, on many fronts, oil consuming countries appear to be less vulnerable now than they did last year. Notwithstanding different base effects, the hike in oil prices should not have the same kind of impact as it occurs in a stronger economic context.
Finally, Saudi Arabia has announced it wishes to offset the rise by increasing its production.
Other than the impact on business activity in consuming countries, higher oil prices also have an effect on retail prices. Where price indices are particularly concerned, particularly in emerging countries, central banks tend to respond with restrictive monetary policies.

EUROPE, THE ECB AND THE UNFOLDING OF THE SOVEREIGN DEBT CRISIS
Last year was marked by rising systemic risk, fed by the connection between sovereign debt and banking sector balance sheets. Defi cit and public debt related problems subsist, but three factors have reduced their impact. First, most countries have committed to reducing their defi cits have already made some progress; the scale of improvements can vary but decisions have been taken and applied. Secondly, after many delays, the Euro zone is looking like it will finally set up the institutions that were lacking to properly assist member states. The zone’s integrity will be better guarded and its legitimacy will be improved. Finally, the ECB was able to react with the required response (two 36-month LTROs) which avoided a refi nancing crisis, as the banking sector was facing a mid-term maturity wall.
One would also have to add the three measures taken in favour in Greece, including the partial debt write-off from private lenders (EUR 100 bn) and a second public rescue package (EUR 130 bn) which will cover requirements until 2014. This does not mean the end of Greece’s problems; the sustainability of Greek debt is far from obvious, even looking forward to 2020. The adjustment of the economy is a momentous task and will take years to achieve.
There is no guarantee that the upcoming parliamentary elections will succeed in reaching a consensus. While disappointments are likely, the mitigation of systemic risk – both perceived and real – has been consolidated.
Differences with 2011 are profound if not immediately visible.
The debt crisis has not disappeared but has entered a new phase that is less chaotic and alarming than it was. Contagion risk is now lower and fears over the break-up of the Euro zone are less acute. The fi nancial crisis has led to a confi dence crisis in the Euro zone whose impact on business is durable; governments will have to be convincing and deliver tangible results.
Similarly, if fi nancial circuits and particularly the intrabank market have not returned to their normal ways, they are on the road to normalisation. Financial conditions within the Euro zone, which had been extremely tense since last June, have improved significantly since January. This will all take time and disappointments will be par for the course (Spain is one, in the short-term) as the problems require long-term action. But if the peak of the financial crisis has reached a head, banking sector fears abate and the risk of a credit crunch is contained, then, confidence should gradually return.
European economies, and particularly the most exposed countries, will suffer from their deficit reduction packages. Although these countries will be in recession in 2012, their situation does not dictate the fate of the area as a whole. Despite a fall in domestic demand, composite indicators within the Euro zone do show a stabilisation in business activity after a clear deterioration in the second half of 2011. After the diffi cult months of Q4, confi dence will return but it will take months to reconstruct what was destroyed in a few weeks. The fact that the world economy is continuing to grow at a satisfactory pace –between 3.5 and 4%, will help to drive confi dence back, but the European Commission has nevertheless forecast negative GDP growth (-0.1%) in the Euro zone for 2012.

THE UNITED STATES: EMPLOYMENT, CONSUMER SPENDING… HOUSING?
Economic data over the past few months suggests a positive trend since the summer of 2011. Despite being sub-average, the improvement in the labour market is a key factor for 2012, and a confi rmation of the trend could prevent any parallels being made with 2011. The resilience of consumer spending is encouraging companies to recruit, with productivity gains slowing down.

Auto manufacturers have increased their use of 24 hour shift work. Furthermore, the improved fi nances of local authorities have meant that staff cut backs have slowed down in the public sector.
In total, 2.3 million jobs were created between January 2011 and February 2012. Generally speaking, the confi dence and fi nancial clout of the corporate sector, lower perceived risk, and the improved stability of the economic environment should all contribute towards more jobs being created this year than in 2011, when the trend had slowed down signifi cantly from April onwards. As we move farther away from the 2008 crisis, company managements now have to look to the future rather than to the past.
Any improvement in the labour market has a direct effect on income and on consumer confi dence. Car sales fi gures (15 million vehicles, annualised, in February – the best figure since early 2008) serve to illustrate these two factors. Access to credit is also crucial, and loans were much harder to come by in 2011. If American banks have remained selective, they have eased their criteria for the past year and interest rates have generally fallen over the period.

CAN THE REAL ESTATE MARKET BE A POSITIVE FACTOR FOR 2012?
After having weighed on growth permanently since 2007, the residential property sector made a small contribution to GDP expansion in the fi nal quarter of 2011. Can this trend continue?
All fundamental data is positive bar one: inventories from repossessions.
But the number of transactions and level of demand will be the main factors determining the market equilibrium and prices. On the basis of combined house prices, average income and interest rates, residential property in the US is clearly affordable.
The benefi ts of buying over letting are obvious but the final difficulty lies with the confi dence of potential buyers, and this factor greatly relies on employment.
A few more months of positive job creations will probably be required before we see households materialising their home investment projects, and therefore absorbing inventories. Banks will also have to show willingness to hand out loans. While their balance sheets are now much improved, banks still have to manage the consequences of the real estate bubble and are still cautious. Home sales (new and old) are still well under historical averages for private buyers but investors have returned to the market for rentals. The combination of low interest rates, low prices and high rents has led to a visible acceleration in the construction of apartments – 33% of new building projects, but only 10% of the housing market. The most likely outcome is a continued stabilisation –not to be frowned upon for households who have seen the value of their investments fall since 2006.
This stabilisation of the market is also the premise of a genuine recovery in prices and residential construction, looking forward to 2013.

CORPORATE INVESTMENT AND PUBLIC SPENDING
While investment budgets only account for a fraction of GDP (10.3%), the growth in investment spending will have an impact on 2012. Tax treatment will be less favourable than it was in 2011 but will still provide an incentive, and the need to maintain productivity gains remains a priority in a highly competitive environment.
Financing does not seem to be problematic and early figures suggest that capital expenditure is being kept at current levels.
In 2011, the annualised contribution of public spending to GDP was the lowest it has been in over 30 years. If the local authority spending cuts can be explained through fi nancial diffi culties (with revenue partly indexed on residential property), at Federal level, expenditure complies with the end of the 2008 stimulus plan.
The Federal government could see a stable spending pattern in 2012, while local authorities have enjoyed higher revenue over the past seven consecutive quarters. While diffi culties subsist for many, California for example, making cuts and savings has become less of a priority.
Better employment fi gures and consumer confi dence, combined with attractive credit conditions do mean that the economy is sitting on a sounder base than it was in 2011. Federal debt and the road to improving public fi nances are the two main areas of weakness. The cost cutting planned for 2013 and the end of tax breaks will impact GDP by 2.9%, all things being equal.
The Congress due to be formed after the November elections could alter this situation. The context is ripe for the Central Bank to adopt a wait-and-see policy after a period of monetary easing,
keeping the option of intervention for later, if required. In the meantime, 2012 can follow its course more peacefully than 2011, while probably remaining below average.

COULD EMERGING ECONOMIES PICK UP SPEED AFTER A PHASE OF SLOWER GROWTH?
Directly and indirectly, the stakes are high around China.
While their importance is declining for emerging economies, commodities still remain a key growth driver. The export volumes and the prices are highly dependent upon the momentum of the Chinese economy and recent indicators suggest more moderate
growth. Consumer spending, production, investment, banking data (new loans) refl ect the restrictive policy led since end 2010 to counter the ebullient property market. The recent 0.5% cut to the reserve requirement ratio was a mere technical adjustment and infl ation dropping from 6.5% to 3.2% (annual) will not, in itself, lead to an easing policy: housing prices will determine how authorities will react. Recent offi cial comments give little hope in the short-term and the on-going political transition could encourage a wait-and-see attitude.
Towards the end of the year, Asia was affected by the disruption to certain industrial sectors, such as automobile or electronics, caused by the fl oods in Thailand. However, statistics over the
past few weeks have shown that production and inventories are returning to normal in the concerned countries. While many countries, including Indonesia or the Philippines, have adjusted
their monetary policy to the fact that infl ation has been slowing down since early 2011, the resilience of external demand and investment, combined with sustained consumer spending should
kick start the economy. But beware of infl ation: tense labour markets, impact of higher energy prices.

CONCLUSION
A combination of negative factors in the vein of 2011 seems highly unlikely. While diffi culties abound – oil, sovereign debt, the environment has changed. Looking at the data available to us today, it seems that the issues are less critically acute than they were last year. Weaknesses persist, some gloom is inevitable, but the shocks of 2011 have gradually been overcome.