Backwards and forwards for 2011 and 2012

As we enter the closing week of 2011, a quick review of this year's markets reveals the following:

(1) The US has outperformed. The S&P500 and NASDAQ are virtually flat for the year, whilst the DJIA is up 4.6%.

(2) The USD is still around. The USD has confounded first half predictions of its demise by rising 1% for the year so far, but has bounced nearly 9% from the low it recorded at the end of April. As always there is a direct inverse relationship between the number of forecassers predicting its collapse and its subsequent strength. Look for the same to apply in reverse. There has been a strong inverse relationship between the USD and global stockmarkets.

(3) Asia & Emerging Markets have slumped. In inverse proportion to the rise of the USD, other previously favoured risk assets such as Asia and the Emerging Markets have slumped in local currency terms, and even more so in USD terms. With AAXJ up as much as 5.5% for the year as at the beginning of May, they are looking likely to end the yeardown 17% in USD terms. Some markets, notably former BRIC darlings India and Brazil, have done even worse with declines of nearly 40% and 28% respectively in USD terms.

(4) Europe has done less badly than it should have. Relative to Asia and EM, the main European indices (just to recap, Europe is the place where all the main problems are) have actually performed less badly, with Germany down by about 18% in USD terms, and France by about 22%. Obviously some of the peripherals have done much worse, as have the financial stocks in these countries. However, the UK (which we're not sure should be included as part of 'Europe' any more) is down by only 8% or so. It seems bizarre that the markets where austerity will bite hardest and where the financial problems are most grave, have outperformed their EM growth 'peers', but there you are: "Markets can remain irrational for longer than you can remain solvent..."

(5) Gold has lost a bit of its lustre. Although Gold is still up by more than 13% for the year, it was up as much as 33% at its high point in early September. Margin restrictions on various commodities exchanges were the catlyst for the sell-off but so was an increasing view that deflation, rather than inflation, is more of a problem. As with Asia and EM stockmarkets, Gold also demonstrated that a stronger USD is negative for commodity prices overall.

(6) The US Economy held up better than feared and despite the best efforts of US politicians. This may simply be because the US consumer remains in denial and because everyone was more worried about Europe.

(7) Oh, and European governments haven't got a clue. Enough said.

Looking ahead to 2012, it seems strange to think that the prospects for the year to come look much the same as they have done for the second half of 2011, with many of the same issues seeming likely to dominate. However, our view is that much of the bad news seems likely to be concentrated in the first half (which could reverse the old adage "sell in May and go away"):

(a) The Eurozone will be forced to restructure and rebuild. If they are determined to support the Euro at any cost, then they'll have no choice but to craft a rescue package that finally looks credible with some sort of joint and several guarantee. Maybe this week's action by the ECB to offer 3 year unlimited funding to Eurozone banks is a foretaste of this: the ECB may not be guaranteeing countries, but it is increasingly acting as the lender of last resort to the banks. Once this restructuring happens, although austerity will be the key and widely adopted policy prescription, markets will bounce in the short-term, and probably by a long way out of simple relief that a solution (of some sort) is finally in place. As one of my clients has said, "hope is not a strategy", and its more than likely that more damage will be done on the way there (maybe that's what's needed to get the German government and its voters over the line), but this 'hope' still seems the most likely outcome.

(b) There's a lot of cash out there and markets are vulnerable to good news. A good piece from Merrill Lynch (entitled "I'm so bearish, I'm bullish") this week highlighted that in the 5 weeks leading to December 15th, global long-only fund outflows amounted to $23bn, putting the amount of cash raised close to ML's previous 'buy' signals on a money flow basis. By the same token, $94bn in inflows to money market funds (which produce a zero return currently) over the same period have been the largest such cumulative inflow since the bad old days of January 2009 (6 weeks before the bottom of the market was reached). As we have seen repeatedly, it doesn't take much to get markets moving upward - sharply (even if the reasons for such moves seem impossible to explain at the time).

(c) When risk returns, you'll want to buy Asia & EM, but not before. As in 2008/9, the worst performers turned into the best performers when risk appetite eventually came back.

(d) A slowdown in China may be good news. Slower growth in China is likely to lead to significant easing, and although the impact of such easing will not be as great as was the case in 2009, it will still have a positive impact on the margin.

(e) Beware US politics. The Europeans have set a new standard for political incompetence in 2011, but the divided government of the US has come in a close second. The willingness of US politicos to hold the economy hostage by taking key decisions over the budget, the debt ceiling and taxes to the brink, should not be underestimated.

So, another year of uncertainty and volatility beckons. Although a recent poll of analysts by Barron's shows an average forecast for +12% growth in the US stockmarket next year, the same analysts said the same thing about 2011 at the back end of 2010. So, I think, did we: our mistake was assuming that just because we knew things were tricky, we assumed that this view had been fully discounted by stockmarkets.

What's the potential for yet more mistaken and utterly unjustifiable optimism in 2011?

Probably quite high. There are certainly plenty of "risks to the downside" as they like to say on CNBC. For that reason, for the time being, we are comfortable in maintaining a much lower exposure to equity than normal, and a much higher exposure to cash than usual. Perhaps we also need to be a bit more nimble to book profits as and when they exist and to cut losses on the other side.

However, if the Mayans are right, the world is going to end in 2012 anyway, so what's the point of worrying? Here's hoping that we're all still around to read more drivel from all and sundry (and yours truly) on December 31st 2012!

With best wishes to you and your family for a Merry Christmas and a Happy New Year.

Steve
e-mail: steve.davies@javelinwealth.com
contact: +65 65577186

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