In the middle of last North American summer, a preliminary assessment I made of the 'Ten Surprises' of 2011 (forecasts for the year) looked bleak. The United States economy had been sluggish during the first half of the year and there were widespread fears that a recession was imminent. The equity market was almost in a free-fall during August and September and the European sovereign debt crisis had become virulent. Gold, however, had exceeded my target of $1,600 as risk aversion around the world drove investors into hard assets. US Treasury securities declined in yield, rather than rising as I expected, because investors everywhere moved away from equities and parked their funds in the government debt of a country with a strong military and the ability to print money.
All this began to change in October. Data for the US economy began to improve and the equity market moved back to where it had started the year. European leaders, recognising the urgent need for a solution to the sovereign debt crisis, began to talk of a treaty change that would move the continent towards a fiscal union. By year-end the 2011 surprises looked much better. A blogger, analysing each of them and giving me partial credit for a few, came up with a score of 50 per cent, which is consistent with my long-term average. Other reviewers were not so generous. My definition of a surprise is a market-influencing event that the average investor would assign only a one-out-of-three chance of taking place during the year, but that I believe is 'probable' (ie. that the event has a better than 50 per cent chance of happening). Here is my review.
The first surprise was that the US economy would have a strong year with real growth of 5 per cent. It now appears that we will struggle to show growth in excess of 2 per cent. I did think that the unemployment rate would drop below 9 per cent and it was 8.6 per cent in November. While capital spending, exports and retail sales were firm, I underestimated the degree of inventory liquidation taking place and how difficult it would be to have a strong recovery without housing playing a positive role.
The second surprise was that the 10-year US Treasury yield would rise to 5 per cent. I thought there would be a linkage between large federal deficits and the reluctance of foreign investors to buy US credit instruments, but I underestimated the amount of risk aversion around the world. With Europe in turmoil and Japanese yields even lower than those of US Treasuries, the 10-year notes dropped below a 2 per cent return. Ironically, yields on US government debt declined even after a credit agency downgrade in August.
In my third surprise I thought the US equity market would have a good year, reaching 1500 on the Standard & Poor's 500. My reasoning was that the index almost invariably sold at 15 times the moving 12-month operating earnings level at some point during the year and I expected S&P 500 earnings to be $95 in 2011 and $105 in 2012. Earnings reported so far for 2011 have exceeded analysts’ expectations. The disappointing performance of the equity markets this summer was caused by concerns that a possible recession was upon us. Real growth below 2 per cent in the first half alarmed investors, who were also concerned that the sovereign debt crisis in Europe and resultant austerity measures there would push the continent into recession and that this weakness would spill over to the United States as it had in most instances in the past. While the US equity market was able to recover its summer losses in the fall, it is still a long way from my surprise target.
Finally, in my fourth surprise I got something right. I thought investors everywhere would begin to believe that a combination of rapid money supply growth and huge debt burdens would cause the major developed countries to print money and debase their currencies. While this might not be immediately inflationary, it would persuade many investors to diversify a portion of their assets into something 'real'. While gold’s price may be a fantasy to some, it has represented a store of value for 4,000 years, and I thought buying by individuals and trade-surplus regions like China and the Middle East would drive up the price. During the year, gold substantially exceeded my target of $1,600 (it got to $1,922), but is below that level at the year-end.
At the beginning of 2011 China had two problems: it was growing too fast and inflation was rising to disturbing levels. In my fifth surprise I thought the Chinese would allow the renminbi to appreciate, which would have the effect of slowing its economy and reducing inflationary pressures. The currency did appreciate during the year from 6.7 to 6.4 to the dollar, or about 5 per cent. This was less than I had hoped for but consistent with my directional expectation. China began letting its currency rise in May 2010. Officials in Washington still view the renminbi as undervalued and believe the Chinese are holding it at an unrealistically low level, but their policy is changing, and I believe it would be a mistake to impose punitive tariffs on goods imported from China. The Chinese are the largest foreign holders of US Treasuries, and where I went to business school, they taught us not to make our creditors angry.
In the sixth surprise I believed the standard of living would continue to rise in the developing world and that people in those countries would improve their diets. This means eating more meat and poultry with a resultant rising demand for feed grains. I also thought that the global warming phenomenon would create more variable weather conditions and the result of this would be more crop failures than crop bonanzas. These considerations led me to the conclusion that the prices of corn, wheat and soybeans would rise. While there was a commodity rally in the spring, all of these commodities were lower at year-end.
Although housing construction remains a key drag on the US economy, in the seventh surprise I expected signs of a bottoming process in 2011. I think that did happen. The data are erratic, but the days of sharp declines in house prices seem to be over. Housing starts also have a better tone. With more than three million homes for sale, we are unlikely to see any significant strength in this area of the economy any time soon, but at least the worst seems to be over.
During last spring all commodities were surging in price and oil was no exception. My eighth surprise was that crude would reach $115 per barrel during the year, and it did. My analysis showed that demand from the developing world would offset conservation elsewhere. In addition I observed that the depletion of the major producing wells in the Middle East and the Americas was only matched by new discoveries, so worldwide production had proven hard to increase. The price of crude has declined since the peak, along with other commodities, but still remains above where it was at the beginning of 2011.
Although President Obama did not withdraw all American troops from Afghanistan at the end of 2011 as I speculated in my ninth surprise, the political and military situation in that country remains problematic. The past decade has taught us that creating a democracy in an historically tribal country is an idealistic notion. I think the administration has lost confidence in Afghanistan’s leader, Hamid Karzai, and is disturbed by the continued lack of stability, the high degree of corruption and the sacrifice of American lives there. I believe our current strategy is to disengage as soon as possible.
The tenth surprise may have been the most prescient. Angela Merkel had been somewhat ambivalent about the role of Germany in the European sovereign debt crisis during 2010. I believed, however, that she would step up and become the leader of a plan to maintain the European Union and the euro as its currency, and she has. I was less convinced that Europe would move toward a fiscal union, which would represent a long-term solution, but the odds of that have improved also. The crisis is hardly solved; rather it seems to be a work in process headed toward a possibly positive outcome.
So there is a review of last year. Now for the Ten Surprises of 2012. As I have in the past, I go through a long process of developing the surprises over several months. I solicit the views of many people, including my third Thursday discussion group of former Wall Street research directors; Gideon Rose and Jonathan Tepperman at Foreign Affairs (a publication of the Council on Foreign Relations); Tom Bailey, the founder of the Janus funds; George Soros; and numerous friends and former colleagues. In the end, the surprises are mine and, good or bad, I take responsibility for them.
The Surprises of 2012
1. The extraction of oil and gas from shale and rock begins to be a game changer. The price of oil drifts back to $85 a barrel and the United States becomes less dependent on Middle East supply. Deposits in Poland, Ukraine and elsewhere prove promising as well. Increased production from Libya and Iraq and reduced demand resulting from the slowdown in worldwide economic activity contribute to the price decline.
2. Earnings for American corporations continue to move higher, driving the Standard & Poor’s 500 above 1400. Raw material prices continue to be soft and business leaders successfully adjust to slower economic growth by using technology to reduce the labour and logistical component of goods and services sold; profit margins stay high.
3. The US economy gets its second wind. Real growth exceeds 3 per cent and the unemployment rate drops below 8 per cent. Recession fears and even the 'new normal' view of prolonged slow growth are called into question. Capital spending, exports and the consumer drive the economy, overcoming fiscal drag. The drop in the price of oil and the rise in the stockmarket improve both consumer confidence and spending patterns.
4. The recovering economy and the declining unemployment rate help President Obama convince the voters that he didn’t do such a bad job in his first term after all. He is viewed as a good speaker but a poor leader who is running against Mitt Romney, viewed as uninspired and whose positions on many issues are unclear. Democrats take back the House of Representatives but lose the Senate in an anti-incumbent wave.
5. Europe finally develops a broad plan to deal with its sovereign debt problem and moves closer to fiscal cohesion. The European Central Bank, the International Monetary Fund, the European Financial Stability Facility and the European Union band together to keep all the countries within the union and to continue the euro as the continent’s currency. Greece has a major restructuring of its debt, Spain and Ireland strengthen their finances during the year, but Italy suffers a 'voluntary' restructuring. A meltdown of the banks is avoided, but imposed austerity causes Europe to suffer a recession.
6. The computer replaces conventional armaments as the principal weapon of terrorists and geopolitical adversaries. Eastern European and Asian hackers invade the data banks of major international financial institutions, causing temporary bank closures. An alarmed G20 meets to address the problem.
7. Concerned over rapid money supply growth in the developed world, investors buy the currencies of countries that seem to be managing their economies sensibly. Scandinavian currencies, the Australian and Singapore dollar and the Korean won benefit.
8. Congress decides its dysfunctionality is harmful to both parties and acts before the November election to deal with the failure of the Super Committee to develop a program to reduce the US budget deficit by $1.2 trillion over ten years. Both defence and Medicare are cut significantly; subsidies for agriculture are reduced and tax deductions for oil, gas and real estate partnerships are modified. Obama pledges to let some aspects of the Bush tax cut program continue if he is re-elected.
9. The Arab Spring finally overcomes Bashar al-Assad and his family’s rule over Syria ends. While Assad’s fall might have been inevitable, it has important ripple effects throughout the region, weakening Hamas and Hezbollah and further isolating Iran.
10. After two years of poor stockmarket performance while their economies came through with high-single-digit real growth, the emerging markets finally have a good year. Growth slows somewhat but favourable valuations enable China, India and Brazil indexes to appreciate 15 to 20 per cent.
Below are several 'also rans' which did not make the Ten Surprises list because (a) I did not think they had a more than 50 per cent probability of happening and/or (b) they were not as important to investors as the ten I ultimately chose.
11. Housing starts to pick up significantly. The strength in the economy coupled with record affordability encourages the consumer to come back into the market and make long-term commitments. The overhang of vacant homes begins to be absorbed.
12. The yield on the 10-year US Treasury note rises to 4 per cent as China continues to invest heavily in hard assets and raw materials and pulls back from putting reserves into the bonds of developed nations.
13. After correcting sharply toward the end of 2011, gold rebounds to $1,800 during the year. Accommodative monetary policies throughout the developed world cause a renewed migration to hard assets by individual investors and sovereign wealth funds. Silver benefits also, rising to $40.
14. Fiscal discipline at the state and local level allows the drop in yields for municipal bonds to continue.
Next month I will discuss each of The Ten Surprises in more detail.
Byron Wien is a senior managing director of The Blackstone Group and vice chairman of Blackstone Advisory Partners LP.