Economic forces shaping 2012

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By Cees Bruggemans, Chief Economist of First National Bank.

Andrew Roberts wrote “A history of the English-speaking peoples since 1900” (2006) in which his views of geopolitical conflict rule supreme.

According to Roberts, his people were seriously challenged four times since 1900: once by an imperialistic Germanic alliance (WW1), once by a Germanic-Japanese fascist alliance (WW2), once by the Communist bloc (Cold War and its regional client wars) and lately by Islamic radicals (9/11 and similar terror).

In the first three clashes the main adversaries all got transfigured out of recognition, while the outcome of the latest conflict is still to be established.

Yet not all ‘major’ history is only or mostly geopolitical power contests (or local politics).

Technical and social changes may be as fundamental in changing the human condition rather than just the power structures and the rules governing them.

Still, the rules of the road are centrally important.

In the long-run, the ‘health’ of society or civilisation determines as much the pace of its technical innovation as the flexibility of its power structures and the fairness of its income, wealth and opportunity distributions.

Although geopolitical reality is expected to continue changing rapidly, with further major adjustments likely in years to come, the main forces shaping 2012 still appear to be mostly financial and economic, as they have been much of this past decade, mainly the consequence of recent system failures and the repair and recuperation thereof.

All pervasive are the technical tinkering and social adaptations steadily changing our capabilities and the choices we exercise.

So, what’s more important in affecting our 2012 outcome?

Everything will feature in some way or other. There will be micro changes (technical capabilities, social fashions), cosmetic stuff (governments changing here and there), big battalions growling (US, China, EU/Iran), the lingering detritus of past financial accidents and rescue missions mounted (fiscal/monetary), with markets pricing every conceivable risk (hysterical and otherwise).

So though one takes cognizance of the Arab Spring (the Fourth Arab Revolt, really, according to the WSJ), and the manner in which this is democratically allowing more conservative religious-based dispensations to take shape in many North African and Middle Eastern countries formerly led by failing nationalist modernisers, and of nuclear-bound Iran and its implication for the greater region, the full geopolitical meaning of these changes will probably only play out in coming years and decades (and not necessarily only or mainly in 2012).

Similarly, the economic rise of China, India, Turkey, Brazil and other former EM countries will increasingly create multi-polar realities, regionally and globally, requiring major changes in relationships which only time will show us, even if the building strains will be noticeable in 2012 (as in 2011).

Despite these building strains, the main reality will probably remain the one prevalent since 2007, namely of rich countries waylaid by financial and economic excesses and in need of reinvention probably taking several years (if not decades).

One consequence might be that the relative economic catch-up of former EM regions with the old rich regions will happen much faster than hitherto assumed, and their relations subjected to change on an earlier timetable.

Thus the building strains may show earlier, perhaps offering earlier discontinuities than hitherto assumed.

But the main shaping forces will be the crisis legacies and their very gradual unwinding, potentially taking many years, shaping global performance at least partially and having an impact on even the most distant bystanders.

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The US addressed its financial system losses three years ago (with an estimated $1 trill in asset losses at banks, hedge funds, insurers and pension funds) and a multiple thereof at households due to reduced property values.

The direct outcome was a credit-restrained banking system due to new regulatory rules, higher bank capital ratios, new risk awareness and ongoing banking and household debt deleveraging as excesses are being worked off.

Also, building and construction sectors reduced to half or less output as housing excesses are being worked off.

This indigestion is one micro aspect slowly being eroded away. There are secondary indigestions, especially in the pervasive unemployment and underemployment (with people losing skill and market value), with the inability to relocate because of the depressed housing market, limited demand, oversupply and $700bn negative housing capital preventing faster labour matching and re-absorption.

There are other micro distortions, embedding greater inequality, as many of the modern technologies need fewer human inputs to power up to global scale, with more of the economic surplus generated concentrating in fewer hands (Larry Summers, Financial Times).

Also, immigration quotas restraining a bigger inflow of global talent, offering protection to well-off middle class offspring, steadily embedding inequality in America ever deeper (Alan Greenspan, Financial Times).

Besides these micro distortions there are the macro ones.

A massive fiscal gearing up to accommodate private de-leveraging has run into political disagreement about budget deficits, government indebtedness and tax and spending priorities. Fiscal cutbacks are being enforced even with the US economy suffering from extensive resource slack and credit/housing headwinds.

The political gridlock of the past year, reflecting a bifurcating body politic (Greenspan), will probably intensify in election year 2012. The US economy will have to absorb uncoordinated fiscal cutbacks in addition to the restrained credit and housing sectors.

That nonetheless can be accommodated, given the healthy corporate balance sheets and strong earnings growth, as many businesses continue with new innovation, cost cutting and productivity to boost income and output.

But it likely will keep things slow overall for many years still. Although the unemployment rate has fallen these past two years, the US participation rate (employment/population) has been stuck in low territory.

The other major pillar is the Fed, maintaining zero interest rates, and shrinking safe haven asset pools through bond purchases, maintaining generous liquidity and encouraging portfolio allocations to overcome inbuilt risk averseness (with leakages overseas at times assuring a weaker Dollar and improved external trade gains).

Its latest attempt is to tweak its communication strategy yet more by providing interest rate forecasts (guidance) for a number of years into the future. Markets are discounting interest rates to remain zero beyond mid-2013 and below 1% beyond December 2014, indicative that the Fed is determined to keep rates as low for as long as possible until resource slack has been acceptably reduced in the presence of low (2%) inflation.

Thus the US economy is being carried in 2012, as in 2010-2011, as much by a still expanding world economy as an accommodative Fed, an assertive corporate sector and a still willing household sector despite headwinds from credit, building/construction and fiscal restraint.

And so the US continues to slowly repair and recuperate, re-inventing as it goes, eventually like a new incoming tide erasing the worst of the crisis damage of 2007-2017.

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Europe also incurred substantial financial asset losses from earlier Central and Eastern European misadventures and participation in Anglo-Saxon securitisation manias.

To this were added peripheral EU misadventures in Icelandic and Irish banking, Spanish real estate and Greek welfare overindulgence.

Some of these micro problems, and an overarching macro fiscal problem, were due to Europe, like the US, responding to the Anglo-Saxon-induced recession with a massive run-up in fiscal support and public indebtedness.

Together with the micro problems, this started to refocus attention on country risk. Some countries had much higher risk profiles (public and/or private) than others AND much less of a growth dynamic longer term.

It called into question debt sustainability, first at the smallest countries (Greece, Ireland, Portugal) but increasingly beyond them (Spain, Italy, but also Belgium, France) once it materialised that Europe, unlike the US, did not have a fiscal and political centre able to share these loads around in stressed times.

All the old qualifications of a currency area without structural convergence, fiscal backstop and single political power structure started resurfacing.

With each inadequate summit attempt to cobble together a few more half-hearted minimalist measures to put out local fires, financial markets insisted on scaling up their stress-testing of the monetary union (euro-zone 17) overall.

As politicians disappointed, the ECB refused to be a soft option, markets insisted on greater risk/reward pricing, bond spreads widened (in peripheral cases dramatically), EU balance sheets at banks, insurers and pension funds deteriorated, counterparty trust faded, the ECB had to increasingly act decisively to keep the monetary transmission mechanism viable, the asset losses kept mounting (potentially also going into the trills) and the EU growth dynamic kept deteriorating.

As EU politicians insisted on fixing the structural problems first, demanding fiscal austerity according to previous misdemeanours and tightening bank capital requirements to the point of restraining credit, and generally by their and markets behaviour inciting greater business uncertainty, higher unemployment and less risk-taking and spending, an EU recession got underway in late 2011 which will probably run through most 2012.

With EU politicians taking time achieving agreement about governance, fiscal and structural growth reforms, and generally only providing limited financial backstops, markets are likely to remain up in arms about perceived risk in sovereign debt and bank funding.

The ECB will likely keep providing liquidity at generous terms, backstopping the EU banking system, while through limited bond-buying keeping stressed peripheral EU sovereign debt markets functional.

Although the ECB is likely to keep differing in approach from the Fed and BOE, in being less inclined to quantitative easing measures, its support actions may prove massive and adequate enough in preventing major market collapses or a deepening and prolonged recession.

Still, the ECB will be inclined to encourage EU politicians to undertake more self-help reform as the only sensible long-term solution to massive structural challenges.

Thus asset market turbulence is likely to remain a major feature at a time of EU recession, affecting sovereign bond spreads, equities and currencies (especially Euro).

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Although China also faces a major existential challenge as it contemplates it next stage of development, with less dependence on infrastructure investment and manufactured exports, with a greater shift to domestic consumption goods and services, with more personal aspirations, expectations and entitlement to accommodate than ever, these are structural shifts that will play out over a number of decades.

Short-term-wise, China has slowed down following policy tightening in response to higher inflation, overheated property and bank credit situations, with global falloffs in export demand.

With inflation now easing, and property less overheated, a new policy easing cycle looms, with GDP growth likely to stabilise at over 8%.

Thus China should remain an important commodity destination, supporting commodity prices.

In contrast, rich country demand will likely grow minimally, placing a greater responsibility on EM space to diversify their export markets (to each other) while in each instance ensuring more domestic growth strength (through greater supply-side and demand-side efforts).

Besides such demand-pull boosts for commodity prices, the massive liquidity generation by rich country central banks (Fed, BOE, SNB, ECB, BOJ) is likely to see substantial leakage into EM and commodity space, in turn boosting bonds, currencies and commodity values worldwide.

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South Africa is likely to see its exports growing through Asian demand, though tempered by EU recession in 2012.

Export prices should remain well supported as compared to import prices. Though oil may move higher, from $110 in 2011 towards $120/$130 in 2012 on the back of ongoing demand growth and Middle East supply scares (with the new technology breakthroughs still too recent to really change the global demand/supply balance), manufactured imports will remain subject to fierce global competition and mostly minimal inflation.

It is a condition that inherently should keep favouring commodity producers, South Africa (and Africa at large) among them.

The turbulence likely to continue in EU market space may at times be risk-unfriendly and pull capital out of South African bond, equity and currency markets, while periods of encouraging global data flow and policy action may see reversals of such movements.

Thus we likely face another year of substantial market fluctuations, with the Rand likely travelling widely in 7-9:$ and 9-11:€ territory and such volatility also reflected in our bond yields and JSE equity prices.

Our GDP growth performance may suffer some falloff on account of export volume reductions to Europe, but generally our modest growth performance will be mostly domestically generated, primarily through gains in household and government consumption along with some gains in public and private fixed investment.

CPI inflation may show some upside potential, mainly due to oil and a higher follow-through from a somewhat weaker Rand compared to 2010-2011. CPI may peak in 6%-7% territory in 1H2012, after which slow subsidence back to the 3%-6% target may be expected.

Though inflation may be higher than liked, the likely modest growth performance and possibly widening output gap, with resource slack remaining noticeable in mining, manufacturing, building and construction, property generally and especially the formal labour force, will likely prevent interest rate tightening in 2012, repo-rate remaining at 5.5% and prime rate remaining at 9%.

At this level, real short-term interest rates will be slightly negative compared to a more normal robustly positive stance, indicative of just how supportive the SARB remains and is likely to remain.

Only noticeable downside growth surprises (and early subsidence in core inflation pressure) might make the SARB inclined to ease rates somewhat further.

With the Fed, BOE and also the ECB likely to maintain ultra low interest rates through 2012-2013 and possibly even well beyond, it isn’t currently obvious what would incite the SARB to start raising rates, and when.

On this score, upside oil and the downside Rand surprises remain the main inflation and therefore interest rate risks facing South Africa.

Iran-related conflict poses upside potential for oil and the lingering EU crisis volatility could see bouts of risk-off pushing the Rand to new lows.

Between them they could create the kind of upside inflation risk that might trigger the SARB to mildly start raising interest rates DESPITE modest growth and lingering resource slack.

For now, though, those volatility risks are assumed to stay within manageable levels, keeping SARB neutral.

Source:  Cees Bruggemans, First National Bank, January 8, 2012.

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