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Trader Talk
Trader Talk is produced by a team of active traders, analysts and various derivatives professionals from multiple organisations. Trader Talk provides comment on equities, commodities, and other financial instruments based on both technical and fundamental analysis.
Crystal ball predictions that surely couldn’t happen in 2012, or could they…?
If you thought that 2011 was a tough year, wait until you read about what 2012 has got in store for investors around the world. With the use of our very own Central Markets crystal ball we have foreseen some of the events that could have a profound impact on your portfolio in 2012. Whilst some of these predictions could be seen as highly unlikely, there is certainly a chance that they could happen. If they do, you want to know what the impact might be.
Each prediction has been given a rating for the probability of the event happening. Please note though, that the probabilities are arrived at purely as a guesstimate and are by no means a scientific calculation.
We will go on to finish by looking at a few of the investments that we believe you should keep an eye on as the uncertain economic climate continues in 2012.
1) The Katla volcano erupts in Iceland
Crystal Ball: The Katla Volcano in Iceland erupts creating an enormous ash cloud to cover the European skies for weeks. Travel chaos ensues and causes huge problems throughout the EU economies.
In March and April 2010 there were a series of eruptions from the Eyjafjallajökull (pronounced: aye-ya-fyah-dla-jow-kudl) volcano in Iceland. The resulting ash cloud forced the closure of airspace in Northern Europe for 21 countries as far east as Latvia, Estonia and Romania, and as far south as Italy. Flights were grounded for around a week, stranding passengers in airports and foreign countries for several days. The second eruption in April saw ash plumes 13km into the sky, with 750 tonnes of ash spewed into the air every second at the start of the eruption. There were around 100,000 flights cancelled and in all about 7 million passengers affected. There were around 200,000 Brits stranded abroad, with many European airport hotels rather helpfully tripling their normal rates. The economic consequences were enormous with around €1.5bn lost to the European economy, while the aviation industry lost around €150m every day.
There are around 33 volcanoes on and offshore Iceland. Scientists are worried because Eyjafjallajökull (Eyja) has an extremely dangerous and potent neighbouring volcano called Katla. History suggests that apparently Eyja has erupted 4 times in the past 2000 years, each time with Katla erupting within 18 months. Further concern comes with the fact that Katla tends to erupt at semi-regular intervals, with periods between eruptions between 30 and 80 years. The last eruption from Katla was in 1918, so an eruption does appear to be overdue. Also, the greater the length of time between eruptions the more spectacular the results. Eruptions from Katla tend to be least ten times as powerful as those from Eyja, however eruptions can potentially be up to 100 times larger.
There was earthquake activity from Katla in mid-2011 which suggested something was brewing. Although nothing materialised in 2011, this could be the year. If there is an eruption from Katla then the consequences could be enormous. Aside from causing some serious weather changes around the world, the economic impact is likely to dwarf that resulting from the Eyja eruption in 2010.
Figure 1: A map of Europe as at April 19th 2010 showing the ash cloud following the Eyjafjallajökull eruption. The eruption from Katla is expected to be at least ten times greater than that of Eyjafjallajökull.
With the right wind direction, Northern Europe could suffer enormous disruption following an eruption of Katla. Once again there would be huge travel chaos and significant effects on tourism in the region. If the eruption of Eyja caused $1.9bn loss to the European economy then an eruption ten-fold or greater in size could have a profound impact on the European economy just at the wrong time when it is already struggling with a likely recession. Furthermore, while the disruption from the Eyja eruption only lasted a matter of days, scientists believe the disruption from Katla could continue potentially for months or even years.
The ash cloud would bring an aviation industry, which is already struggling to cope amid the hardships of the current economic climate, to its knees. A number of budget airlines could go to the wall, while even some of the larger carriers could be significantly impacted. During the Eyja disruption, British Airways and Lufthansa both lost around £20m per day, while easyJet lost around £5m per day. The strain would also come on cashflow with customers reluctant to book flights.
The travel stocks would certainly feel significant strain whilst other leisure segments which are reliant on tourists, such as hotels, pubs and restaurants would also struggle. A volcanic eruption in Iceland in 2012 could prolong European recession. The knock-on impact would see risk appetite retreat further, putting even greater pressure on bond yields in the Eurozone and potentially force countries such as Spain and Italy towards a bailout from the ECB and IMF. An extreme case scenario could bring the Eurozone crashing to its knees, unable to cope as bond yields soar and countries struggle to refinance their debts. But this surely could not happen, could it?
Probability of occurring: 20%
2) The Eurozone breaks apart
Crystal Ball: As we move through 2012, investors become increasingly exasperated by the lack of progression by the politicians in tackling the issues surrounding the European sovereign debt crisis. Summit after summit of the EU leaders fails to come up with any discernible solution as the politicians remain steadily behind the curve. The bond markets target one profligate Eurozone country after another. After becoming frustrated with peripheral countries failing to get their houses in order Germany finally cracks, refusing to underwrite the Eurozone project anymore. Germany pulls out of the Euro and forms a smaller currency area. Along with other prudent nations such as Finland, Austria and the Netherlands, the “Euro-mark” becomes their currency unit. This leaves the peripheral European nations to fight for themselves, with the “Euro-lira” plunging in value and investors in these countries taking a significant haircut on their asset values.
One big problem is that if you include interest repayments, according to Bloomberg in 2012 the world’s biggest economies (G7 + BRICs) will need to refinance around $8 trillion of government debt. There is a huge oversupply of bonds that will need to be auctioned this year. While there is never a shortage of demand for Japanese debt (c. $3 trillion matures in 2012) or US debt (c. $2.8 trillion matures), countries in Europe could face sizeable problems with significant competition to find buyers.
The Eurozone must refinance just over €1 trillion in 2012. Italy has around €335bn of bond redemptions due this year and that is before around €55bn of interest payments are factored in. France needs to re-finance around €287bn, Germany around €223bn and Spain €85bn.
If demand for these bond auctions fails to materialise government bond yields will soar. This could expedite the bailout of Italy and Spain. The trouble is that the bond markets continue to suggest that some sort of default (be it orderly or disorderly) is highly likely for some of the peripheral “Club Med” countries. It just depends on how far the ECB choses to go to help the peripherals. Despite Nicholas Sarkozy thinking he is an equal of Mrs Merkel, the ECB has yet to bow to the wishes of the market and issue common bonds or turn on the printing presses. The reason is that the Germans do not want to underwrite its spendthrift partners while also having a deep rooted fear of a return to the days of Weimar hyperinflation. It would appear that Germany still has the final say, but surely it would not leave the Euro, or would it?
If there was a split, a two tier Europe would see a big divergence develop between the new currencies. With market confidence high, a Euro-mark would strengthen quickly probably towards an equivalent of $1.50/$1.60 on Euro-Dollar. Whereas its toxic twin, the Euro-lira, could easily struggle back towards parity with the Dollar or perhaps even lower. Stock market reaction would likely see an initial sell-off. However, following a re-basing the improvement in market confidence due to the increased clarity, the outlook should improve once again and see markets eventually recover.
Probability of occurring: 40%
3) FTSE 100 retests 3461, the March 2009 low
Crystal Ball: As western economies struggle with recession, China chooses not to send good money after bad and refuses to invest in Europe. Stock markets tumble with the FTSE 100 retesting its March 2009 lows.
The equity markets creaked under the pressure in 2011 as the sovereign debt crisis stymied the Eurozone and investors rushed to exit from their riskier assets. The FTSE 100 shed over 5% of its value in 2011 but that is nothing compared to what 2012 could bring. Investors may have to come to terms with a financial meltdown in the Eurozone. As the politicians continue to bicker, procrastinate and fail to act decisively, the equity markets may plummet. Recession could engulf the western economies, with corporate outlook statements becoming increasingly negative. Top line revenue would suffer and with margins already to the limit analysts would rush to slash forecasts. The heavyweight sectors in the FTSE 100 such as the Banks, Miners and Oil majors would come under huge pressure, with even the most defensive stocks targeted for indiscriminate selling.
The technical analysts do not see this as necessarily such a crazy prediction. In 2008 as the credit crunch hit, the FTSE 100 Index fell from around 6500 to below 3700 in under ten months – a fall of over 43%. The techies have been foreseeing doom and gloom on the equity indices at least since August last year. The reason is that the FTSE 100 would complete a huge head and should top pattern on a move below the critical July 2010 low of 4790. A break below this support would imply a downside target of 3475. From current levels this is a decline of almost 40%.
4) Finally we look at some investments which we believe you should be mindful of in 2012
For investors, 2012 is expected to carry on where 2011 left off, full of volatility. At this stage, the politicians continue to muddle along behind the curve with little prospect of a discernible resolution to the sovereign debt woes within the Eurozone. Risk appetite shows little sign of returning any time soon, so investors continue to prefer investments towards the safe haven end of the scale.
In currencies, the Euro should be avoided at all costs due to the continuation of sovereign debt woes. The Eurozone is almost certainly in recession and while there is an ever increasing likelihood of liquidity creation via an ECB QE programme, this should ensure the Euro remains depressed in 2012. The US Dollar will continue to attract investors as risk remains off the table. That is not to say that volatility will not be seen this year. Investors may struggle with the comparatively sturdy US economic recovery on one hand and the fluctuating daily news flow on the Eurozone on the other. Also, if the US economy continues to improve then perhaps the Fed will not be required to turn the stimulus taps on again. This would give investors further reason to look towards the Dollar. The Japanese Yen was the only currency to outperform the Dollar last year and this strong performance is likely to continue. The Scandinavian currencies should also perform well due to ongoing economic prudence and strong economic management.
With regards to government debt, again there is no reason to think at this stage that the strong performers of 2011 will not continue. US Treasuries, UK gilts and Germans bonds were all the safe haven choices as investors shunned peripheral Eurozone debt last year. Although the strong gains seen in 2011 are unlikely to be repeated, as the Eurozone crisis continues, investors will continue to favour safe haven debt. The risk this year would be that the European politicians actually succeed in taking the decisive and bold steps necessary to resolve the sovereign debt crisis. This would see yields in embattled countries such as Italy and Spain pulled lower again and away from the 7% danger zone on the 10 year . However, if history is anything to go by, the procrastinating, self-interested European politicians will not be making serious progress any time soon.
Assets in the commodities arena are likely to show contrasting performances in 2012. Despite a significant correction in Q4, gold still managed to add over 10% to its value throughout the year. Gold tends to perform well during times of negative real interest rates and while inflation is likely to fall in 2012 real interest rates will remain negative. The propensity for central banks to use quantitative easing as a policy tool to kick start ailing economies in 2012 should continue to drive gold prices higher. The technical chart has taken a hit in the past month or so, but the fundamentals remain strong for gold. The outlook for oil is a tough call. The slowdown in global growth will be a drag on the oil price, however the supply constraints and the tensions surrounding Iran are supportive. The consensus range for the end of 2012 is that Brent crude will average between $100 and $120. After three quarters where the oil price had been drifting backwards, the technical outlook is improving again. As the key November high of $116.50 looks as though it will be re-tested, a break would re-open the strong resistance at $120. The support around $100 is a key level on the downside for oil, so this $100/$120 range seems to be quite fair. As ever, base metal prices are hugely dependent on the progress of the Chinese growth story. In 2011, copper lost 22% while zinc lost 25%. Growth expectations for the emerging giant are being pared back and this should mean that base metal prices remain under continued pressure.
For equities, in the absence of a “big bazooka” for the Eurozone, financials should be avoided and certainly those with exposure to the embattled common currency area. Consumer-facing sectors such as the travel and leisure stocks, personal goods and high street retailers remain under severe pressure, while if the outlook statements are anything to go by this will not be abating any time soon. As emerging market economies, such as the BRICs which have been the engine room of global growth for the last few years, see a slowdown of growth, the resources stocks have suffered. Business confidence in China has suffered and growth in house prices has stumbled. Despite the positive December manufacturing PMI data, the prospect of a hard landing in China should not be discounted. This could be a massive impact on global markets. The FTSE 350 Mining Sector fell 30% in 2011, if concerns over Chinese growth proliferate this is another high beta area which should be avoided.
The stocks that performed the best in 2011 tended to be the defensive, high quality names, which had diversified international revenue streams that generated solid earnings, were well capitalised, and paid out a good income stream. There is no reason to think that these stocks will not continue to perform well. The Tobacco stocks, British American Tobacco and Imperial Tobacco, had a storming 2011 and can be expected to outperform well into 2012 as the economic headwinds show little sign of abating. Telecoms are also a strong segment. Vodafone is another company which should follow on its fine showing in 2011 as the balance sheet continues to strengthen following a series of strategic asset sales. Aside from the strong cash flow, the dividend payout is a big plus along with the fact that Verizon (in which Vodafone owns a 45% stake) is now also beginning to return cash to its shareholders.
Other strong defensive stocks that look set for a upside in 2012 include beverages giant Diageo, GlaxoSmithKline in the Pharmaceuticals, with Royal Dutch Shell and BP in the Oil & Gas Producers also looking good. Utility companies with good growth prospects such as Pennon Group should also be considered. On the more speculative side, companies with good exposure to a US-led recovery could also be interesting. Media agency WPP group is one such company, while industrial supplier specialist Wolseley should also be in line to benefit.
Whilst the market volatility looks set to continue during 2012, this should ensure that there are some good trading opportunities. As with 2011, the best profits will be made by investors who can time their entry points well. In a tough 2012 it is vital to stay on top of current market developments as you never know, the predictions from the Central Markets crystal ball may just come true.
This report was written by Richard Perry – Chief Market Strategist at Central Markets www.centralmarkets.co.uk The writer does not hold a position in the company featured, but client accounts may. The material in this report has come from the company’s corporate website and Alpha Terminal.
