Fundamental Outlook 2012
City Index January 10, 2012 3:03 PM
<p>To put this year’s loss on the FTSE into greater perspective, the last 26 years have netted an average yearly growth in the UK’s benchmark […]</p>
To put this year’s loss on the FTSE into greater perspective, the last 26 years have netted an average yearly growth in the UK’s benchmark index of 7.48%. During that time, there have only been six bearish years and interestingly enough, 2011 would actually mark the best bearish year for the FTSE 100 over the last six years.
This will inevitably beg the question, with so much still at stake in the eurozone, is the worst yet to come? One’s likely answer to this question will be defined by whether one sits in the sceptical or optimistic camp.
The chart below shows the rarity of two successive bearish years on the FTSE 100 (2001 and 2002) and the fact that the average year gains immediately following a bearish year is 8.58%.
2011 was dominated by three key themes:
Trading in 2011 has been dominated by three key themes: Market shocks, slowing growth and the eurozone debt crisis.
Three main market shocks have contributed to sharp equity falls and damaged longer term market sentiment: the Arab Spring Uprising, Japanese Tsunami and US Credit Rating downgrade.
The Arab Spring Uprising, typified by the revolution and toppling of the long standing rulers of Tunisia, Egypt and Libya, triggered sharp rises in the price of crude oil on global supply fears. Nymex crude oil reached a record high of $114.83 at the start of May, and this rise applied significant pressure on stocks globally initially as traders had to come to terms with higher crude oil prices escalating business costs.
The Japanese earthquake and tsunami on March 11 triggered the first real market shock of the year, with the Japanese Nikkei falling over 1000 points before quickly recovering, and European indices following suit in similar fashion. The tsunami was devastating to both Japan and companies that relied upon produce from the region, such as car manufacturers.
In early August, the somewhat surprising cut of US’s top notch credit rating by Standard and Poor’s, after weeks of uncertainty over the raising of the US debt ceiling, alongside a deterioration in the sovereign debt crisis played a role in the biggest equity losses of the year. From August 1 to 9, some seven trading days, the FTSE 100 lost as much as 1100 points or 19%, putting the UK index in bear market territory and hitting its lowest point in the year, 4791.
Slowing growth and the eurozone debt crisis has also significantly impacted market sentiment this year, and these two themes are likely to play a major role in how markets progress next year. Investors have been particularly troubled by the somewhat obvious slowdown of economic activity both in developed nations and developing economies such as China. This has raised fears that a global double dip recession could be on the cards.
At the same time, and linked to the growth issues, is the fact that the eurozone sovereign debt crisis has put the whole eurozone on the brink of failure, with Greece requiring new bailouts and Italy and Spain struggling to raise finance at acceptable costs in the debt markets. The debt crisis has claimed the heads of multiple governments, with a swift change in power in Spain, Greece and Italy. Swift change in the governments of these countries has coincided with lack of political unity and progress in Europe as a whole, with countless disagreements and leader bashing in public, which culminated in the seeming isolation of the UK from the EU. And what’s more, potential credit ratings downgrades for Europe’s top notch club has kept market rallies short lived and several unanswered questions going into 2012.
Outlook for 2012
2012 is likely to be dictated by a number of important events but three key themes, which will likely be inextricably linked, stand out:
- Eurozone sovereign debt crisis
- Slowing global growth
- Quantitative easing (global monetary policy)
Note that all of these key themes for 2012 are a mere continuation of some of the major themes of trading in 2011, and therein lies part of the problem.
Eurozone sovereign debt crisis
Another year on and the eurozone debt crisis has become even more cemented, with bond yields of Italy and Spain escalating excessively and investors hugely concerned that the crisis could trigger financial Armageddon. Whilst it may be somewhat premature to signal an impending doom to the world’s markets, there are significant points that must be addressed in order to reinstall market confidence.
First and foremost, we are still no closer to understanding the full scale of liquidity at offer to bail out indebted states should the situation deteriorate further. The ESM (Europe’s permanent bailout fund) is to be capped at €500 billion, and early indications that this may change in March was put firmly to the sword by Angela Merkel. The EFSF has failed to be effectively leveraged the four to five times it had been predicted to have been, whilst third party investment into Europe’s bailout funds remains far from certain. The failure of the ECB to step up its bond buying efforts has made the above issue all the more crucial. The market is looking to the ECB to start buying bonds much more aggressively and to become a de-facto lender of last resort. To do so could potentially lift market confidence in an instant, but the Treaty ramifications are proving too heavy an obstacle, along with huge pressure from Germany to prevent such a scenario. At this point, it may be worth pointing out that Italian benchmark bond yields remain stubbornly high, and the country has over €300 billion worth of maturing bonds to pay for next year.
The lack of political unity lies at the heart of many of Europe’s problems. No sooner after the last EU Summit, when European partners combined together in proclamations of saving the eurozone and anti-British rhetoric, had the first cracks started to appear, with several states indicating that having talked through the conditions discussed and agreed in Brussels, their appetite for these conditions had waned somewhat.
The idea of a new intergovernmental treaty being agreed fully by March next year, with final drafts tentatively agreed by the end of January, not only applies a ‘make or break’ date on the debt crisis, but it also has the ability to keep the markets firmly headline driven until then as investors pay obsessive attention to all rumours and rhetoric out of the euro area.
Of course the sovereign debt crisis has had a somewhat crippling effect on financial firms in 2011 and is likely to continue to play a huge role in the ability of bank shares to recovery in 2012. There has been evidence of a distinct lack of confidence in interbank lending markets and there remains a possibility of a new global credit crunch. The move by the key central banks in the world to start cheaper dollar liquidity operations was a move aimed at unblocking the lending markets but the heart of the problem remains unsolved. This will be a crucial area that traders need to keep an eye on in 2012.
One thing is for sure, when talking about the eurozone debt crisis, one cannot help sense that we have barely entered the eye of the storm as of yet. Of course, much of whether the storm dissipates or not will be dictated by political unity and progress made in the first quarter of 2012.
Slowing global growth
Slowing global growth is likely to have a significant impact on company performance next year and their ability to weather the storm of any realisation of double dip fears. The eurozone economy is expected to dip back into negative GDP territory, a prediction of ECB President Mario Draghi, whilst there is a significant threat that the UK could also experience at least one quarter of negative GDP, a consequence of the eurozone being Britain’s largest trading partner.
However, FTSE 100 traders should not just pay attention to slowing growth in London, Berlin, Paris and Brussels. Slowing growth in the US and, to a larger degree China also pose significant threats on the UK’s benchmark index.
Growth in the US has slowed over the course of 2011 and whilst fears remain over the US’s stubbornly high unemployment rate and static housing market, economic data over the past few months has helped to ease immediate fears of a double dip here.
China however is likely to be a key focus next year, with growth in the world’s fastest growing economy slowing of late. With key mining stocks on the FTSE 100 having a heavyweight bearing on the UK Index, the ability of China to keep growing, and thereby maintaining healthy metal and resources demand, is likely to play a crucial role in the ability of the FTSE 100 to bounceback in 2012. And this leads me onto the third a final theme for 2012: Quantitative Easing (Global Monetary Policy)
Quantitative Easing (Global Monetary Policy)
Whether or not the world’s central banks can deliver the ‘ace up their sleeves’ that investors so desire, will be important not just for indices but general market confidence as well, at least in the short term. Whilst arguments still rage in bars, pubs and trading floors throughout the city as to whether quantitative easing works in the first place, the evidence over the last few years seems to persuade that at least in the short term, market relief has been found.
The mere fact that the world’s main Central Banks launched a co-ordinated effort to keep bank liquidity topped up late 2011, at a time when interbank lending was showing signs of shutting down, shows their vigour to act when needed.
The Bank of England restarted the printing presses recently in the UK and whilst initial asset purchases were capped at just £75 billion, there is wide market expectation that this cap could be lifted as soon as February, when the BoE has a chance to digest the next quarterly inflation report.
The Federal Reserve has so far kept QE in its armoury as a viable option, but is likely to wait until the US economic situation shows signs of deterioration. Perhaps one of the positives of the Fed is that its Chairman, Ben Bernanke, rarely fails to deliver when the market is most at need, and it is from this perspective that there remain muted expectations in the market that QE3 can still happen in 2012. Were this to happen, it could increase large capital flows into emerging economies in search of higher yields of returns and this can funnel its way back into the resource sectors and commodities.
Much of the world’s global economic recovery could well be dictated by China’s ability to keep its economy growing at such a fast, yet consistent, pace. Hawkish Chinese monetary policy throughout the year has hampered resource stocks on the FTSE 100 by slowing metal demand. The last month has seen the first real indications of the Chinese to switch its policy to a more dovish tone. The first step towards this change was indicated by a surprising cut in the bank reserve ratio requirement. Historically, this is widely seen as the first step towards a potential interest rate cut within the ensuing six months. If China delivers this and, more importantly, Chinese growth can be realigned upwards, this could help to ease global growth pressures and potentially give mining stocks in the UK a fillip to push higher.
Other issues of note:
Presidential Elections may trigger market sensitivity
Aside from these key themes for 2012, the markets will also likely see strong reactions and potential sensitivity to politics, specifically in the US, France and to a lesser extent the UK. 2012 sees Presidential Elections take place in the US and France and the financial markets can be somewhat edgy during important election years whereby the result may not be so transparent.
Whilst it is too early to see how the US Presidential Election may pan out, with Obama’s key challenger as of yet unnamed, recent polls suggests that French leader Nicolas Sarkozy could well lose out to rival Francois Hollande. Given Sarkozy’s dual leading role, alongside Merkel, in co-ordinating potential solutions to Europe’s debt crisis, this could well be one of the most important French elections, not simply for France, but for the eurozone as a whole. Hollande is seen as having a much stronger determination to promote French interest in Europe and has already indicated a willingness to renegotiate the inter-governmental treaty agreed in December. Whether or not this is a simple campaign pledge to win over more voters is yet to be determined but clearly if Sarkozy was seen as more of a compromising figure, a hard hand of Hollande could be more disruptive to any progressive policies designed to solve the crisis, should these be seen as anti-French growth.
Snapshot of stocks and sectors to keep an eye out for in 2012:
Miners – Could well play a defining role in how the FTSE 100 performs, given the weighting. Much of the miners’ progress this year will be defined by investor risk appetite (this is a traditionally badly hit sector when risk appetite is low) and Chinese monetary policy.
Financials – this was a badly underperforming sector in 2011 and needs to be kept a close eye on. The FTSE 350 banking sector has lost around 30% in 2011, compared to the FTSE’s 9% loss as sentiment was badly hit by underperforming fixed income trading, exposures to sovereign debt and a lock down in interbank lending markets. All three of the factors need to be closely watched in 2012.
Retailers – it has been a terrible year for many of the UK’s key retailers, with HMV and Game Group just two stocks that have been badly hit in 2011. With strong headwinds on the high street and consumer spending still struggling as earnings capacity is hit in the face of austerity plans, both in the UK and abroad, this could be another difficult year for Britain’s retailers. It will be important to keep an eye on pressured earnings power in correlation to any increase in QE by the BoE, which may lift inflationary pressures. Burberry may well be one stock to watch in particular, having fallen 27% from its June 2011 peak of 1610p. The luxury goods retailer has benefitted from strong demand in emerging markets such as Asia, but should global growth start to slow even more, the positives from the last two years could start to subside for the fashion retailer. From a technical level, strong support lies around the 1000p mark, which would mark a key 38% Fibonacci retracement level.
Government spending reliant stocks – With the US election pending, the economy is likely to be a defining line for voters. Given the storms that have raged through Capitol Hill over the last six months on how to balance the budget and reign in the spiralling US fiscal deficit, this could be another volatile issue. One aspect is likely, part of the Republicans and Democrats pledged mandates to take/recover the White House and Congress is likely to be weighted in cutting government spending. The key for traders will be to highlight the likely companies that could be hit by this likely reduction, such as defence contracted firms.
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