2010 had a mixed tally. Risk markets performed well in general, but much of it was due to the past, present, and future effects of actual and anticipated easing, rather than a concrete set of data that can be said to show a fundamental improvement in the shaken financial system. 2011 will probably continue on similar notes, with QE expectations, Eurozone troubles, and China`s economic performance being the main themes if no black swan event hits the market. Of that we have plenty in stock, and only provide a small, yet choice selection in this brief overview of what could drive trends in 2011, as seen at the beginning of the year.
Tensions in the Korean Peninsula: The world has forgotten about the North Koreans and their bombs. For the past few days parties and celebrations were in everyone`s minds, and the mutterings of the eccentric autocracy far away in East Asia were wished away without much thought. But the problem is real, and won`t go away by just being ignored.
North Korea is the joker in the game, since no one knows where it will pop up, and what it will do when it does. There is no guarantee that the Korean Communists will not declare an all-out war against their alienated brothers to the south, and no guarantee that they will do so either. We are simply held hostage at their whim, and can do no more than hope that they act like rational beings.
But if we expect rational beings to escalate crises in stages, as a sign of anger and frustaration, the North Koreans have been doing precisely that. They have successively intensified the tone of their actions, and as we all know, recently went so far as to bomb an inhabited South Korean island. They seem utterly unwilling to bow to pressure and will not be satisfied unless some of their specific demands are met. The U.S., on the other hand, is reward NKorea very much for its extravagant actions.
We believe that 2011 will see more serious escalations of this crisis, provided that the U.S. does not bow to the pressure and accept some of the North`s demands. A war here would probably send the dollar and gold higher by more than 10% in short order in 2011.
European Sovereign Debt Crisis: The Eurozone crisis is clearly the main item on news reports when we speak about risk and downturn. At the same time, however, positions have already been taken on this issue, and it will take a real surprise to suddenly shift perceptions on where the Euro and the common market are headed. That said, the Euro`s fate will probably keep providing most of the headlines this year as it did in 2010, since the stakes are high, the potential for loss is great, and the authorities will not be give up easily.
There seems to be two conflicting viewpoints in the Eurozone leadership as to what should be done about the crisis. We are made to believe that the Germans, and their followers want to be stern and strict with the delinquents, while the nations at risk of default naturally want to be treated as gently and leniently as possible. While it is conceivable that such a division of intentions and desires of the two parties exists, the distinction rapidly breaks down in the face of reality, since, faced with the caprice and whim of the markets, both sides are very well aware that the stakes are too high to be too nitpicky about a couple of hundred billion Euros here and there. With almost Eur 900billion already committed in one way or another to the bailouts in order to keep the union intact, we find it extremely hard to believe that Germans can say no, but of course they will be protesting and making faces right up to the foot of the wedding bed.
We do not envision a European default in 2011. Barring a repeat of the events of 2007-2008, we believe that the troubled nations will be bailed out, with the real costs of this only materializing after the next elections in the European nations. A very fragmented picture will then arise, making the attainment of the traditional European consensus an intractable matter. The Euro will probably be the victim of the ensuing conflicts and quarrels.
U.S. Home Prices: The U.S. economy is the largest in the world, and for us, the single most important variable that will determine whether it can lift itself out of its Japanese malaise is the home price trend. Homes are a household`s most valuable possessions typically, and they compensate for the lack of savings when prices are appreciating. Home price appreciation, in other words, serves like a proxy savings mechanism masking the fact that the consumer barely sets aside any money for rainy days, since, if the worst were to occur, he/she can just sell the home and move to a more modest environment, meeting the necessary expenses with the difference. As we all know, homes also used to serve as immobile cash machines in the blushing days of the home price bubble, but we don`t think anyone is entertaining the possibility that those days will return any time soon.
Given the heavy weighting of the house in the family`s net worth, we believe that nowadays there is a strong relationship between a family`s sense of financial well-being, and the value of its dwelling. That implies a strong reflection on consumption trends overall. And if we add to that the obvious psychological impact of forced home sales and crowds of homeless wandering around, price trends must be expected to have a relationship with one`s appreciation of the economy`s performance, and the outlook in general.
What happens to home prices in 2011, then, will remain a crucial indicator of economic performance. We believe that there won`t be any tangible improvement, or trend change for this entire decade, barring runaway inflation.
China`s Interest Rate Policy, and EMs: Our opinion is that China remains the most important part of the puzzle on the future of interest rates, currencies, and gold prices, and speculative trends in general. Apart from the well-publicized fact that it is the fastest growing nation in the world nowadays, the Chinese are involved in almost every single speculative game in the world, be it the U.S. Treasury market, FX trends, commodity (including gold and oil of course), or stock prices. Money that originates from, or because of China, pumps up all these markets, as we have discussed in these pages many times before, and if the Chinese factor is removed it is clear that there is nothing of equal size or significance to let the speculators speak about decoupling, shifts in focus and paradigms, strategic rebalancing, and the many other forms of the same circular argument.
The Chinese will surely be raising their interest rates multiple times this year. That much is a given, since not doing so would risk placing the country in the miserable state of the helpless Vietnam just to the south. But whether they can stop the Chinese people from creating inflation through policy change is harder to say. On the one hand, we know that the Chinese consumer is very different from the American consumer, and will be easily cowed to increase savings and tighten spending at a slight sign of uncertainty about the future, especially if it is being communicated by the (almost) all-powerful CCP. On the other hand, the Chinese consumer is swimming in cash, has the highest savings rate in the world, and has been exploited to no end by Chinese entrepreneurs who have been working them at third-world wages even after the country has long lifted itself out of third world status.
Chinese interest rate policy, its duration, and the magnitude of cuts, then, will be the most important event of the year, and furthermore, since it is certain to happen, it will be the keystone of all analytical directions for 2011. Our outlook is that China will slow down this year, partly because of the government`s rate cuts, and while we are certain that the country will at one point suffer an economic collapse, we are skeptical that 2011 will be that point. The CCP is only too easily cowed to ease, and if there is any sign that the economy is getting weaker, we believe that they will be only happy to lower rates once again (or they could just tweak the yuan, ignoring the screams of dismay from Washington).
Federal Reserve and QE-X: The Federal Reserve can never be too far from our minds, as we probably owe the stock market rally, and the improvements in risk sentiment to its declared intention to do all it takes to keep inflation from turning to deflation. The Fed is watching corporate credit interest rates, mortgage rates, industrial output, and the output gap, as well as the inflation expectations of the population, and sees, apparently, only the slightest signs that matters may turn better in the near future. With inflation staying surprisingly low throughout the robust performance of the markets, and even of the economy at large, the central bank sees no reason to reduce the pace of monetary accommodation, and as we know, is instead planning to flood the global markets with ever increasing amounts of dollars in order to boost risk sentiment, and force people to shop.
For 2011, whether the Fed will announce a third round of quantitative easing once the present program ends will be the main topic of discussion. While we recognize that the U.S. economy may look better at the end of the first phase, we believe strongly that QE2 will not be the final one, and the Federal Reserve will keep pumping more money into the system in Japanese style, until the bond market rebels, or world trade collapses, depriving the government of its major buyers of debt in Asia. For now, though, Mr. Bernanke`s public, and legitimate Ponzi Scheme continues. It will end when there are no more buyers to recycle cheap dollars to.
Protectionist Pressures: Trends in global trade, output, and politics do not change rapidly. Fluctuations happen all the time, but it takes some time, and considerable incentive before people will permanently reconsider the ways and means of the past, and readjust their outlook in accordance. Protectionist pressures in response to the rising unemployment rates around the developed world likewise take some time to build up, but from our point of view, there is little doubt that eventually, in three or four years time, the world of trade and finance will be very different from what it is today. And we are not talking about cosmetics, fine-tuning, or temporary adjustments that allow business as usual. Protectionism as the antithesis of liberalism, will force a major change in the way business is conducted around the world.
Arguably, the most significant steps towards protectionism will not be taken under the Obama administration, which, for all its talk of change, has in fact changed a miniscule amount of details from the common practice of the Bush years and before. Barack Obama has surrounded himself, especially in the economics field, with distinguished, yet orthodox names like Larry Summers (although he has left recently), and Tim Geithner, who are very unlikely to deliver the kind of change that the American public wants. That is not to say that Mr. Geithner or Larry Summers are wrong on all, or even most of their opinions, but the policies advanced by them do not deliver the kind of drastic change that the electorate wants, and in the absence of that change, utterly fail to provide the kind of populistic accommodation that would soothe the desire.
In sum, as Barack Obama`s term completes its first half, the risk of a backlash keeps increasing, as change fails to materialize. This year we might see, at most, a couple of complaints being launched at the WTO against the Chinese, and more verbal pressure applied on the nation`s leaders. But that will be the limit, and it would be enough to save the President from the wrath of the voters as they turn to vote for the most sensible populist they can find on the ballot list.
Rare Earth Materials Shortages: There are many points of contention between China and the democratic nations of the world. China has land and sea border problems with India, Japan, Vietnam, and Malaysia, Philippines, and others. The country has fought wars with Vietnam, the Soviet Union, and India over the past forty years. Nowadays, however, the most likely avenue for the release of escalating tensions is the WTO with trade issues providing the cheapest and easiest opportunities for China bashing.
Needless to say, the Chinese have been provoking their adversaries to do just the same, with the plans to cut back on rare earth materials production being interpreted as a clever ploy to boost domestic producers of high-tech equipments through anti-competitive quotas imposed on the rest of the world. As the country produces about 90% of the world`s total output in this sector, it does have the leverage to impose prices and corner the market, as well as isolate and eliminate competition through selective supplying of raw materials. Since China is in no position to provide outright subsidies to Chinese companies due to fears of disastrous retaliation, imposition of quotas on rare earths creates a good alternative method to boost the nascent domestic high-tech sector. The only problem is that, while reaction has been slow, China`s partners are not buying this game, and it will be very interesting to see how the response to Chinese policies develops around the world, as 2011 progresses.
Israel and Iran: This issue has not really left the center stage of events at any point, but with the alleged Stuxnet operation of the Israeli secret service that delayed Iran`s capability to produce enriched Uranium considerably, the stakes seem to be higher. The Iranians have no intention of stopping their fuel enrichment programs, as this is seen as a matter of national pride and prestige, while the concerns of the Western World are focused on the enrichment issue alone. In consequence, a quick solution to the problem seems highly unlikely this year, raising the bar for an eventual military conflict that could send the FX and commodity markets upside down, and open the door to an enormous degree of volatility. It is safe to assume that the Americans will do everything in their power in order to prevent a military conflict in the region, and the most likely outcome would be their success in controlling the Israelis while intensifying the pressure on the Iranians through international channels. But the risk that events will procede in an unpredictable and dangerously chaotic fashion cannot be disregarded fully.