Outlook 2012: Year of Reckoning

As the calendar turns to 2012, it is worthwhile to look ahead at what we might expect from investment markets in the coming year.  While a variety of meaningful challenges will carry over from 2011, how these events play out will also bring the potential for attractive new opportunities as we move through 2012.

Investment markets have been in a state of flux since the outbreak of the financial crisis several years ago.  Periods of government stimulus fueled euphoria have been followed by phases of unsettled reality that the underlying problems have yet to be fully addressed.  At the root of the ongoing uncertainty are the financial excesses that were accumulated during the prolonged economic expansion from 1982 to 2000 and then compounded further in the years since the bursting of the technology bubble at the turn of the millennium.  Put simply, there is far too much debt in the financial system today.  And the time finally arrived a few years ago where markets began the process of cleansing itself of this debt and moving toward getting back into better fiscal shape.  While this process has played out in some areas of the market, most notably the corporate sector and selected households, debt deleveraging has not been allowed to fully run its course to this point.  Instead, global leaders and central banks have engaged in policy acrobatics since the outbreak of the crisis to postpone this debt unwinding.  While these actions have provided time for the financial system to stabilize, global markets will remain volatile until this cleansing process is finally allowed to play itself out.

The mounting crisis in Europe may finally bring global markets to this reckoning phase in 2012.  Europe faces the following dilemma.  Seventeen countries across Europe share the common euro currency.  To join the currency union, each country ceded control of their monetary policy to a central authority in the European Central Bank.  As a result, each country only controls its fiscal policy.  Since the outbreak of the financial crisis, a growing number of countries across the region are increasingly buckling under the weight of too much debt.  First, it was smaller peripheral countries like Greece, Ireland and Portugal.  Now it is much larger core countries like Italy, Spain and even France.  But none of these countries can take the traditional steps of devaluing their currency to stimulate growth and manage their debt because they share the euro with other countries.  Thus, the only other option is to engage in austerity, which is to raise taxes and cut spending to increase revenues to service their debt.  But the problem with austerity is that it stifles growth, which leads to reduced tax revenues over time to service the debt.  So investors lose confidence that these countries will be able to continue to make debt payments in the future.  Consequently, the value of this debt falls since investors no longer want to own it.  This increases the borrowing costs for these countries, as they have to pay a higher interest rate so that investors will still buy their new debt.  The result is that less money left over to service existing debts, pushing the value of this debt down further.  Adding to the problem is the banks, which are the primary holders of the debt of these countries.  With the value of this sovereign debt falling, the capital levels at these banks effectively evaporate, which threatens their ability not only to lend money but also to even stay in business.  And this is where the threat of another 2008 Lehman Brothers type crisis begins to take hold.  Putting all of this more simply, European banks are facing bankruptcy from holding the debt of European countries facing bankruptcy, and the primary place for these European banks to go for support are the European countries that put them into this bind in the first place.  As this circular dilemma spirals, it appears increasingly likely that we may finally enter a reckoning phase as we move through 2012.  Several countries warrant particularly close attention in this regard.  These include Italy, Greece and Hungary, all of which are leading candidates at the moment for unexpected shocks that could lead to a contagion episode in the financial system.

The fact that global financial markets may finally be forced to face these debt demons in 2012 would be positive from a long-term perspective.  Certainly, any debt unwinding episode will likely come with a fair amount of short-term market turbulence.  But until markets are forced to fully engage this debt cleansing process, we will continue to experience persistently wild and unpredictable volatility.  Once this deleveraging process is finally allowed to play itself out, however, the economy would be refitted and the basis would be formed for the start of a new secular bull market (think 1945 or 1982).  Once the turbulence subsided to arrive at this end point, this would be a very positive outcome moving forward.

Given the prospects for a reckoning event in 2012, the question becomes how best to position portfolios for such an episode.  At the same time, portfolios must also be positioned to benefit if global policy makers continue to act aggressively to further delay the inevitable deleveraging process.  Thus, the focus in portfolio construction is on asset classes that stand to benefit from either outcome.  Leading among these are four primary categories.

The first is U.S. Treasury Inflation Protected Securities (TIPS).  If a contagion event were to occur, U.S. TIPS would likely benefit from investors flocking to safe haven Treasuries for protection.  However, if monetary policy makers continue to successfully delay the deleveraging process through further aggressive stimulus, U.S. TIPS would also benefit from the asset inflation that would likely accompany this additional money creation.

Next is Agency Mortgage Backed Securities (MBS).  During a crisis event, Agency MBS would also benefit due to the fact that these securities are now essentially backed by the U.S. government.  The fact that they offer a higher yield relative to comparable U.S. Treasury debt is also a plus.  On the flip side, if monetary policy makers inject more stimulus, Agency MBS would likely be a direct beneficiary as the U.S. Federal Reserve has openly stated that this area of the market would be the main focus of any further asset purchases (QE3) in an effort to lower mortgage rates even further.

The third is Utilities Preferred Stocks.  If a financial crisis were to erupt, these securities are among the best protected given the fact that regulated utilities will continue to receive the steady cash flows from customers that will still pay to keep their lights on.  Conversely, further monetary stimulus to delay the debt unwind would consist of keeping interest rates near zero, and since these securities have yields in the 5% to 8% range, these securities would remain particularly attractive from an income generation and real returns perspective.

The fourth is Precious Metals including Gold and Silver.  A European crisis would put the survival of the euro currency, which is the second largest currency in the world, into serious doubt.  As a result, demand would increase for alternative safe haven currencies, and both Gold and Silver are appealing in this regard given their hard asset characteristics.  And if policy makers instead act with aggressive monetary stimulus to thwart a crisis, the resulting currency devaluation and associated potential for inflation would also support strong demand for hard asset protection.

Two additional asset classes serve the purpose of weighting portfolios toward the potential for one outcome over the other.

Stocks would benefit in the short-term from the further delaying of the deleveraging process.  But given the fact that global policy makers have been resolute in trying to squelch the debt unwind, the probability associated with this outcome remains meaningful.  In order to help neutralize the risk associated with these stock exposures, it is worthwhile to emphasize the more defensive areas of the market including consumer staples such as food and household products as well as utilities.  Not only will these categories provide the potential for upside if the stock market rises, but they also provide the best downside protection if the market were to plunge into decline.  And if a financial crisis were to fully explode, the opportunity would eventually present itself to purchase high quality stocks at extraordinary discounts.  Thus, maintaining a considerable cash allocation within this targeted stock allocation is worthwhile so that the powder is fully dry to capture these opportunities as they present themselves. 

U.S. Treasuries would benefit most in the short-term if a crisis episode were to unfold.  Although yields are already low and uncertainty remains about the fiscal outlook, U.S. Treasuries continue to provide an idea destination for safe seeking investors during times of crisis.  For example, Long-Duration U.S. Treasuries gained +31% in the second half of 2011 versus the stock market that was down over the same time period.  These securities also provide an ideal way to hedge against a rising U.S. Dollar and its associated impact on Gold and Silver, which is an added plus for maintaining positions to this area of the market.

It promises to be another interesting year in 2012.  Financial markets may potentially reach a reckoning point that while difficult may finally put the current crisis behind us.  At the same time, we are likely to witness a continuing wave of revolutionary change in many parts of the world including most notably the Middle East.  The threat of new military conflict remains meaningful, particularly with Iran highlighted by recent activity in the Strait of Hormuz.  And 2012 will also bring another Presidential election here in the U.S.  These are interesting times, and 2012 promises not to disappoint in this regard.

Best wishes for a healthy and happy New Year.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Published by Eric Parnell

Registered Investment Advisor

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