It is time to get our stories straight. How scary is Europe right now? How bad would a Chinese hard landing be? How likely is a Middle East confrontation? And, from an investor’s perspective, which of these stories could move markets the most and which are red herrings?
In 2011, the overseas stories dominated investment performance, causing markets to careen between bullish and bearish sentiment. Each time hope for a stronger recovery budded, optimism was dashed by a string of dismal stories emanating from the Middle East, Japan and Europe. Throughout the year, headlines portrayed each story as frightening.
As we rolled into 2012, fears stemming from the Arab uprisings were re- placed by worries about confrontation. Japan was slowly recovering, allowing attention to shift to China. And concerns over Greece were rotating to Spain and away from banks.
As investors, our challenge this year is to sort through the global headlines to determine which could have a meaningful impact on our economy and markets, and which are likely to resolve themselves on their own. Here is how we rank the stories.
Number 1: European Debt Crisis
The European markets are likely to riot a number of times this year. A number of European Union countries have unsustainable debt levels. The proposed cure (called austerity) is painful and unpopular. In order to get needed reforms passed, governments must be “forced” into action. Markets help by attacking bonds and stocks of countries deemed to be in trouble, raising the specter of default and the possibility of the end of the European Union. In the end, some action (nev- er enough) is taken and markets are calmed – at least until the next riot.
All of this drama swirling around debt and austerity is important, as it can impact market volatility, but the more important story is the underlying concern of a banking crisis. We had one of those in 2008 in the U.S. If we ever have one in Europe, the impact here could be severe.
Fortunately, the European Central Bank, which has the ability to support the euro-zone financial system, has signaled it intends to prop up banks through a number of measures. Fears of a contagion to the U.S. have been reduced. Still, while the headlines scream “market riots in Spain” (or Italy or another country), the ECB is worth watching. If it shows an unwillingness to continue to help the banking system, that could be cause for real concern.
Number 2: China
Emerging markets, of which China is the largest, are the engine of future global growth. Without growth, economies can’t create enough jobs or income. It is not sufficient to have global growth in our own country; we need it elsewhere as well. So China matters.
Recently we learned that China’s economy has weakened. At the same time inflation, which can dent growth, is ticking up. Scary? Not yet.
China is in transition. Its decline in growth is not the result of a global contagion, but rather a policy decision to control inflation that resulted from property speculation. It is an engineered decline, and therefore not unexpected. But there is still much debate over whether China will have a hard landing vs. a soft landing and how much global demand will be reduced while China tries to get it right. For now the Chinese government appears in command of the growth trajectory, but investors should be on guard for a change in outlook.
Number 3: Middle East and Oil
Rising oil and gas prices can hurt consumer spending. When oil prices rose to $110 a barrel in February, there were fears that the U.S. recovery could falter if we saw a sustained spike in oil prices. Over time, oil is likely to rise due to greater industrial production world wide and temporary reductions in refinery output. Gradual increases can be tolerated by the economy. However, a sharp jump in prices – often associated with an event such as an open conflict between Iran and Israel or supply disruptions due to unrest or upheaval – cannot. The challenge for investors: confrontation is hard to predict.
Not all headlines are created equal. Bad news and setbacks are not always scary. We need to rank the stories from extreme to mild risk and from high to low probability. European contagion, Chinese collapse, confrontation in the Middle East – these all would have a high impact but come with low probability. A mild to moderate recession in Europe, a Chinese soft landing and range-bound oil prices offer higher probability but lower potential impact. Investors need to monitor the stories behind the headlines for their likely impact on portfolios.