There is a nervous and gloomy mood out there. The Ten Surprises of 2012 have a positive tone, and for the past month I have been discussing them with our clients and others in large and small groups. Most investors believe the United States economy will grow at only 1% to 2% and the European sovereign debt crisis will remain unresolved, with Greece and possibly others being forced to withdraw from the Union. No progress will be made by Congress in reducing the budget deficit until after the November election. Emerging market economies around the world will slow, and we will have another difficult year for global equity market performance.
This prevailing negativism provides a favorable background for equities since sentiment is a contrary indicator, but the fundamental forces have to be better than consensus expectations for stocks to rise. Most investors believe that the developed world is in a prolonged period of slow growth as the enormous public and private debt accumulated during the last thirty years is unwound. These investors think Europe and the United States have been living beyond their means and this problem will not be solved quickly. It is a secular condition, and while we have already endured more than a decade of disappointing investment performance, the pain is not yet over. What's more, they think, you cannot get relief by investing in the developing world because economies there are suffering from high inflation and slowing exports. In addition, China may have real estate and bank loan problems that will make investing there treacherous. The democracies of the West appear to have dysfunctional governments which are incapable of solving the problems facing their economies. Europe and the United States must engage in some form of austerity program to deal effectively with their financial difficulties, since we can no longer count on “growing our way out of this mess.”
It was against this background that I began to work on The Ten Surprises last fall. The definition of a surprise is an investment-related event that I believe is “probable” (i.e., has a better than 50% chance of taking place), but which the average investor would assign only a one-out-of-three chance. I have been doing this since 1986 and my long-term average has been to get them reasonably on target about half the time. There were two major reasons why I believed 2012 might work out better than most investors expected. The first was that economic data for the United States were improving month after month. The economy was finally developing some positive momentum. Unemployment was falling, housing was bottoming, inflation was tame, auto sales were improving, exports were benefiting from the dollar decline and corporations were spending some of the ample cash on their balance sheets on capital equipment.
In Europe I thought that the continent had so much more to lose than to gain by a break-up of the Union that some solution (albeit not long-term) would be found to maintain the euro and keep the membership intact, although I realized that some defaults were inevitable and a recession was likely. I also thought that world equity markets were at reasonable valuations. While I acknowledged the powerful negative long-term arguments made by academics like Ken Rogoff of Harvard and others, I thought that 2012 might be a reasonably good year for investors.
For the past decade I have believed that the price of crude oil has been headed higher. I started thinking that when it was $40 per barrel because we were only finding new recoverable reserves at about the same rate as the existing wells were being depleted and the demands of the developing world were increasing substantially year after year. I now think that the ability to extract oil from rock deposits will result in the United States having more domestic crude production during 2012 than in the previous year, which is something that hasn’t happened in probably twenty years. While environmental difficulties may impede production in the eastern part of the United States, production in less populated areas like North Dakota, Wyoming, Montana and Texas should encounter fewer problems. What’s more, fracking and horizontal drilling possibilities are prevalent throughout the world in places like Poland, Ukraine and China. As a result the developed world may finally become less dependent on Middle East oil. I view this as a “game changer” and in my first surprise I think that the price of crude could decline to $85 per barrel this year.
In my second surprise I expect the Standard & Poor's 500 will rise to 1400 at some point during the year. It is off to a good start, having risen to more than 1300 before the end of January. The driving force for a better equity market will be improved earnings and modest valuations. I expect operating earnings for the index to be $105, so the market was only selling at only 12 times at the beginning of the year. Usually (but not last year) it sells at 15 times at some time during the year. In addition, the overall index yields more in dividends than the 10-year U.S. Treasury yields in interest for the first time since 1958, with more than 40% of S&P 500 stocks having dividend yields higher than the 10-year Treasury rate. Many of these are high-quality multinationals with brands recognized throughout the world.
My third surprise is based on the expectation that real gross domestic product growth in the United States will exceed 3%. It is almost impossible for the economy to grow at that rate without housing providing some help, and there are finally signs that a bottoming process is underway. The vast overhang of unsold homes will prevent a sharp pick-up in housing starts, but the worst seems to be over. The unemployment rate also seems to be trending lower and could drop below 8% before year-end. The payroll cutbacks at the state and local government level are largely behind us and an increase in private sector employment resulting from improved manufacturing competitiveness is becoming evident.
We should recognize, however, that federal government expenditures are running at 25% of gross domestic product, well above the 20% level of the past 60 years. This represents an enormous stimulus program. At the beginning of 2013 the automatic cutbacks in defense and healthcare entitlements resulting from the failure of the Congressional Super Committee to come up with a $1.2 trillion deficit reduction program will take place. In addition, the Bush tax cuts will expire. These two events will create an enormous fiscal drag, but for now the combination of our $1 trillion-plus fiscal deficit and the natural momentum of the economy should enable real growth to reach 3% for the current year.
This is a national election year and no list of surprises would be complete without anticipating some unexpected twists in the outcome. I expect President Barack Obama to have a second term. That might not seem to be a surprise to some, but many of his supporters four years ago are disappointed with his first-term performance. His approval ratings are low, and independent voters as well as all Republicans believe the country is headed in the wrong direction and that change is needed. In spite of all that, I believe the economy will be the most important influencing factor. If voters believe the economy is improving and more jobs are being created, Obama has a good chance of being reelected. If the economy is growing at only 2% or less, I think he is in trouble. The ultimate Republican candidate will be the crucial determinant. I believe Mitt Romney would provide the most formidable competition. The other candidates lack appeal to a broad enough constituency to be elected, in my opinion, but Newt Gingrich would wage a powerful campaign if he is selected.
The real election surprise could come in Congress. There is a general belief among the electorate that our representatives in both houses are doing a poor job. Unlike in the past, being an incumbent could turn out to be a liability. The House of Representatives becoming Democratic and the Senate shifting to a Republican majority at the same time would be a shocker. A change in control in the Senate is more likely.
In my fifth surprise I see the European Union remaining intact and the euro continuing as the currency for all those countries currently using it. The members of the Union have invested a great deal in its conception and implementation and its failure would be a tragedy. The stronger countries, notably Germany, France and the Netherlands, have gained a lot in terms of trade. Some southern tier countries such as Greece and Portugal may have abused their membership by borrowing excessively at low rates to fund their deficits. In the overall scheme of the Eurozone, Greece and Portugal are of minor importance. Italy is a critical factor and its membership must be preserved.
There are likely to be some significant “voluntary” or involuntary defaults resulting in the write-down of the sovereign debt of several countries, but I believe the euro and the European Union will survive the year intact and that will be a surprise to many. The restructuring of the debt of the weaker countries will threaten the continent’s banking system and institutional aid will be necessary to prevent a financial crisis just as help was needed for the U.S. banking system during the subprime financial meltdown of 2008.
We have already had some indications of the probability of the sixth surprise. This one is based on the idea that computer hackers in Eastern Europe and the Far East are more effective than the firewall builders working in the financial services industry in the West: they invade the databases of some banks and force several large ones to close for several days until the accuracy of internal records is determined. Several large banks have already formed a group to work together to deal with this problem, as reported in The Wall Street Journal. An adversary of the United States could inflict considerable harm by undermining confidence in our banking system. This could prove to do more damage than a more violent attack and could be done from an offshore location.
For several years I have recommended that investors allocate a portion of their portfolios to gold as a kind of insurance against a calamity in financial assets. I still believe in that concept, but the seventh surprise is that the currencies of the countries that are managing their finances responsibly appreciate in value. These would include the non-euro Scandinavian countries as well as Singapore and Korea in Asia. I also think that the currencies of countries with a favorable natural resource to population ratio, such as Australia, are likely to do well. In a generally risk-averse environment a segment of the investment community will be looking for a safe place to “park” some of their money, and selective currencies as well as precious metals should do well.
Most investors do not expect any significant legislative action to deal with the U.S. budget deficit until after the November election. With the automatic spending cuts in healthcare and defense and the expiration of the Bush tax cuts scheduled for January 1, 2013, I think it is too much to ask of Congress to expect them to deal with these changes in what might be a lame duck session during a period that includes both Thanksgiving and Christmas. I think a courageous President or Congressional group will take the initiative and try to reduce the budget deficit sometime before the election, and that is the eighth surprise. Since cutting entitlements is a sure way to lose the votes of some people, many believe action before the election is unlikely, but some in Congress may conclude that facing the budget problem directly and taking action will impress voters who know that entitlement cuts are inevitable.
The ninth surprise involves Syria. The repressive regime of Bashar al-Assad is likely to go the way of similar dictatorships in Libya and Egypt. The real surprise here relates to the fact that Syria has been an important ally of Iran and a supporter of radical groups like Hamas and Hezbollah. An end to the Assad family’s rule in Syria would be a positive for Middle East stability and would further isolate Iran. Many have asked why I didn’t have an Iran surprise. For a while during the process, I had a surprise saying the United States and Israel would bomb Iran, and for a while I had one saying they wouldn’t. I now believe that a combination of sabotage and assassination has slowed the nuclear weapons development program there sufficiently so that an overt attack is not likely.
Finally, in the tenth surprise I believe investors will be rewarded for holding the equities of the larger developing countries like Brazil, India and China. For several years the economies of those countries have grown in excess of 5%, but the markets have not done well. I think that valuations have become compelling. While I think that the developing economies will slow during 2012 from their recent pace, earnings for many companies will continue to justify higher prices.
So there is the thinking behind The Ten Surprises. Now let’s see how the year turns out.
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