January 2013

Although growth around the world from the developed markets of Europe and the United States to the emerging markets of China, India and Brazil has slowed, many stock markets have done well.  The German DAX Index, for example, was up 29% in 2012.  This has taken place against a geopolitical background of instability.  Iran continues to pursue a nuclear weapons program, there is unrest in Egypt over the constitution, Israel and Hamas have a fragile cease-fire in Gaza, China is in conflict with Japan over the ownership of certain islands and with its Southeast Asian neighbors over fishing rights.  The list goes on.  I think we will all have to get used to seeking opportunities in an uncertain world, but it has probably always been that way.

The Ten Surprises of 2012 were above average in anticipating how the year would work out.  I got the three most important ones reasonably right:  the Republican candidate and outcome of the U.S. election, the performance of the Standard & Poor’s 500, and the European Union holding together with the euro remaining the basic currency of the continent.  My definition of a surprise is an investment-influencing event that most money managers would only assign a one-out-of-three chance of happening but which I believe is “probable”, meaning the event has a better than 50% chance.  Here is a review of last year.  If you are more interested in the future, skip to the end of the essay where The Ten Surprises of 2013 are listed. This is the 28th year I have done this.

In my first Surprise of 2012 I said that the price of West Texas Intermediate crude would drop to $85 a barrel.  It was about $100 at the beginning of the year and rose to $110 in March.  I thought that slow growth in the economies of Europe and the United States would reduce demand for energy products, but the real reason for the decline would be new supply.  The Bakken formation in North Dakota was only producing 100,000 barrels of oil from rock in 2005.  At the beginning of 2012 it was producing about

500,000 barrels as a result of hydraulic fracking.  In December 2012, 728,000 barrels were lifted and production is expected to continue to increase.  The price of oil dropped below $80 a barrel in June and ended the year at $92.

I thought the Standard & Poor’s 500 would rise to 1400 in my second Surprise and it got there in March. Investors were cautious at the beginning of the year, which provided a good sentiment background for the market to do well.  I thought profit margins would stay high as companies continued to invest in capital equipment to reduce labor costs.

 

Revenues might only increase modestly but earnings would be strong enough to move the market higher. After a correction in the spring which drove the index almost back to its January starting point, the S&P 500 ended the year at 1426.

In my third surprise I proved too optimistic.  I thought the U.S. economy would “get a second wind” and grow at a 3% real rate in 2012.  Instead, it struggled to grow at 2%.  I did believe the unemployment rate would drop below 8% and it was 7.7% in December in spite of the devastating impact of Hurricane Sandy on the economy of the Northeast.

President Obama was having a very tough first term.  His leadership skills were being questioned, the economy was weak, the high level of the budget deficit persisted and job creation was disappointing. In spite of all this I thought he would be re-elected in November although he appeared to be beatable.  I analyzed the broad range of Republican candidates from Bachman to Santorum and concluded that Mitt Romney would be the eventual nominee even though he was uninspiring to the electorate and unclear in many of his positions.  I consider myself lucky on that one because at various times other candidates seemed to be gaining favor. I also thought the Democrats would take back the House of Representatives but lose the Senate and I got that part of the fourth Surprise wrong.

I thought the European Union would hold together, Greece included, with the euro remaining the continent’s main currency, and it has.  I said that Greece would restructure some of its debt and Spain and Italy would strengthen their finances.  I am disappointed, however, that Europe has not made more progress toward fiscal convergence. Overall, the fifth Surprise turned out pretty well.

In the sixth Surprise I thought the computer would prove to be an instrument of both corporate and geopolitical warfare.  There have been cyber-attacks on both financial institutions and the intelligence frameworks of various governments. This is likely to be an increasingly significant problem going forward as the hackers grow in ingenuity and the firewalls prove inadequate.

One of the most costly trades for the hedge-fund community in 2012 was going short the euro against the dollar.  In spite of Europe’s problems the euro was strong and closed the year above $1.33.  In my seventh Surprise I thought a number of currencies would benefit from the rapid monetary expansion going on in the major developed countries and I cited the Singapore and Australian dollars, the Korean won and the Scandinavian currencies as beneficiaries.  All of these currencies appreciated against the U.S. dollar, but I don’t consider this one to be one of my more successful Surprises.  None of them outperformed by more than 10%.

In the eighth Surprise I thought that Congress would recognize the dangers of what has become known as the “fiscal cliff” and act before the year ended.  I should have realized that during the year all political attention was likely to be focused on the election and no serious legislative progress on the budget would be made.  Now it appears we have basically gone over the cliff and it is up to Congress to deal with this problem in early 2013 or the U.S. economy is in serious danger of entering a recession.

I expected the regime of Bashar al-Assad to fall in 2013 in the ninth Surprise.  Through a combination of severe military force and aid from other nations, particularly Iran, he is still in power, but in a weakened state. It is not clear how much longer he will hang on. What is perhaps more troublesome at this point is that chaos among the various factions in Syria is likely to erupt once he goes.

Finally in the tenth Surprise I thought 2012 would be the year when we would see strong performance from the emerging markets.  For the previous three years the emerging economies had done well but their stock markets had not performed.  I thought growth in the developing world might slow somewhat but valuations were low enough to attract investors and the markets were in a position to rise.  While some markets, notably India, did climb in sympathy with the strong performance of equities in Europe and the United States, I do not think the emerging markets as a group did particularly well.

While the goal of The Ten Surprises is to stretch my own thinking and that of others about the possible events of the new year, it is always gratifying to get more than half of them pretty close to the mark and that happened in 2012.  The development of the Ten Surprises is a long process that begins in October and I am still tweaking them in the week between Christmas and New Year’s Eve.  I get a lot of help in formulating the Surprises.  I want to thank my Third Thursday group of former research directors of Wall Street firms; Gideon Rose and Jonathan Tepperman of Foreign Affairs and others at the Council on Foreign Relations; George Soros, who has provided counsel on the Surprises since the 1980s; Tom Bailey, founder of Janus Funds; the person I refer to as The Smartest Man in Europe; and other friends, acquaintances and colleagues who have given useful suggestions.  In the end, however, the Surprises are mine and, right or wrong, I take responsibility for them.

1. Iran announces it has adequate enriched uranium to produce a nuclear-armed missile and the International Atomic Energy Agency confirms the claim. Sanctions, the devaluation of the currency, weak economic conditions and diplomacy did not stop the weapons program. The world must deal with Iran as a nuclear threat rather than talk endlessly about how to prevent the nuclear capability from happening.

 

Both the United States and Israel shift to a policy of containment rather than prevention.

2. A profit margin squeeze and limited revenue growth cause 2013 earnings for the Standard & Poor’s

500 to decline below $100, disappointing investors. The S&P 500 trades below 1300. Companies complain of limited pricing power in a slow, highly competitive world economic environment.

3. Financial stocks have a rough time, reversing the gains of 2012. Intense competition in commercial and investment banking, together with low trading volumes, puts pressure on profits.  Layoffs continue and compensation erodes further. Regulation increases and lawsuits persist as an industry burden.

4. In a surprise reversal the Democrats sponsor a vigorous program to make the United States independent of Middle East oil imports before 2020. The price of West Texas Intermediate crude falls to

$70 a barrel. The Administration proposes easing restrictions on hydraulic fracking for oil and gas in less populated areas and allowing more drilling on Federal land.  They see energy production, infrastructure and housing as the key job creators in the 2013 economy.

5. In a surprise reversal the Republicans make a major effort to become leaders in immigration policy. They sponsor a bill that paves the way for illegal immigrants to apply for citizenship if they have lived in the United States for a decade, have no criminal record, have a high school education or have served in the military, and can pass an English proficiency test. Their goal for 2016 is to win the Hispanic vote, which they believe has a naturally conservative orientation and which put the Democrats over the top in

2012.

6. The new leaders in China seem determined to implement reforms to root out corruption, to keep the economy growing at 7% or better and to begin to develop improved health care and retirement programs. The Shanghai Composite finally comes alive and the “A” shares are up more than 20% in 2013, in contrast with the previous year when Chinese stocks were down and some developing markets, notably India, rose.

7. Climate change contributes to another year of crop failures, resulting in grain and livestock prices rising significantly. Demand for grains in developing economies continues to increase as the standard of living rises. More investors focus on commodities as an investment opportunity and increase their allocation to this asset class. Corn rises to $8.00 a bushel, wheat to $9.00 a bushel and cattle to $1.50 a pound.

8. Although inflation remains tame, the price of gold reaches $1,900 an ounce as central bankers everywhere continue to debase their currencies and the financial markets prove treacherous.

9. The Japanese economy remains lackluster and the yen declines to 100 against the dollar. The Nikkei 225 continues the strong advance that began in November and trades above 12,000 as exports improve and investors return to the stocks of the world’s third largest economy.

10. The structural problems of Europe remain largely unresolved and the mild recession that began there in 2012 continues. Civil unrest subsides as the weaker countries adjust to austerity. Greece proves successful in implementing policies that reduce wasteful government expenditures and raise revenues from citizens who had been evading taxes. European equities, however, decline 10% in sympathy with the U.S. market.

Every year there are always a few Surprises that do not make the Ten because either I do not believe they are as relevant as those on the basic list or I am not comfortable with the idea that they are “probable.”

11. Having traded below 20 for most of 2012 the VIX Volatility Index surges 33% to 30, providing a bonanza for traders. The decline in the S&P 500 increases market volatility.

12. The Newtown, Connecticut, massacre finally convinces Congress to do something about gun control. As a first step they ban future civilian purchases of automatic weapons, including handguns, with clips of more than ten rounds and require more extensive background checks on all gun purchases. “It should not be easier to buy a gun than rent a car” becomes a slogan.

13. Frustrated by an inability to increase revenues through raising income taxes, Congress begins to consider different approaches. There is more talk of a value-added tax as well as a wealth tax, and these ideas appear to be slowly gathering momentum.

14. Congress decides that high-frequency and other computerized algorithmic-based trading practices are putting the individual investor at a disadvantage. A transaction fee designed to slow down frenetic activity and protect against “flash crashes” and glitches is imposed on intra-day trades.

15. The planet finds itself saturated with technology. Semiconductor companies, software providers, social media favorites and personal computer manufacturers all report disappointing earnings and provide discouraging guidance. They lead the overall market lower. Users finally agree the present state of the art is fast enough and connected enough, and that they have more “apps” than they know what to do with. Apple bucks the trend and trades above $700 as its products continue to enjoy enormous success abroad.

Next month I will discuss my reasoning behind each of The Ten Surprises of 2013.