2011 Review and 2012 Outlook

By Rob Marstrand on December 30, 2011

This year has been marked by conflict, confusion, volatility and fear.

Of most concern is the euro-zone train wreck. Countries are broke. So are banks. This is putting the supposed political harmony of the European Union under huge strain.

Greece, Portugal and Ireland are now dependent on emergency funding. Spain and Italy are dangerously close to default and dependent on European Central Bank bond buying. And what was once a “peripheral” problem is edging closer to the “core.” Even proud France could lose its AAA credit rating.

EU leaders engage in bouts of grandstanding to buy time. But the debt and spending problems have not been solved.

Europe desperately needs something that is unlikely to come any time soon: strong private sector economic growth that continues for many years. Only this way can distressed European nations bring their debt burdens back down to sustainable levels. The alternative is default.

Not Just a European Disease

The US is in almost as bad shape. The US federal debt grew 9% during 2011, as politicians bickered and avoided tackling the budget deficit. Standard & Poor’s downgraded the country’s long-term sovereign credit rating from AAA to AA+.

According to the ratings agency, “the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what […] would be necessary to stabilize the government’s medium-term debt dynamics.”

The bond market isn’t listening.

In the face of this downgrade, US Treasury bonds and the dollar have strengthened. Why? Because no other asset classes can absorb the “flight to safety” from distressed Europe and global stock and commodities markets.

China: An Unsolved Puzzle

Investors couldn’t make up their minds on China. Was the economy overheating? Or was it cooling down? Was inflation out of control due to a credit boom, or were all the banks going bust as the result of a real estate bubble?

These questions are unresolved. But Chinese stocks have already factored in a negative outcome. Chinese equities are on a P/E of 7.9 compared to a P/E of 13.5 for the S&P 500. US stocks are almost twice as expensive as Chinese stocks, in other words.

Chinese stocks have also suffered from a spate of fraud accusations. Some of these will turn out to be justified. But most will probably prove to be short sellers talking their own books.

We have suffered from this development, by way of our investment in Chaoda Modern Agriculture (Holdings) Ltd. (HK:682) / (PINK:CMGHF). Chaoda is still investigating the fraud allegations. And audited financial results for the year to June 30 are still pending. It seems we will have to wait patiently for a little longer.

Will Democracy Come to the Arab World?

The Maghreb and the Middle East have been hotspots too. Arabs across the have demonstrated against heavy-handed governments and, in some cases, forced out regional strongmen.

So far, popular revolutions have toppled Egyptian and Tunisian governments…there has been civil war in Libya…and major civil unrest in Bahrain, Syria, Yemen, Morocco and Algeria. There has even been trouble in oil-rich Saudi Arabia.

Western journalists have dubbed this phenomenon the “Arab Spring.” And they characterize it as a quest for democracy. It’s more likely that the trigger was food price inflation and economic hardship. One country tipped over the edge. And the people in neighboring countries were emboldened to revolt as well.

Whether dictators will be replaced by modern, secular democracies remains to be seen. But there are signs that extremists may fill the power vacuums in some countries. Only time will tell.

Japan Sends Uranium Prices Tumbling

Japan suffered severe earthquakes, followed by a massive tsunami. The tsunami caused a nuclear crisis at the Fukushima Daiichi power plant.

This threw global supply chains for many Japanese companies into disarray, as crucial parts could no longer be delivered “just in time.” Germany announced that it was getting out of the nuclear power business.

Uranium prices, which had been rising steadily, plummeted.

Doing the Twist

Against this backdrop the world’s central banks have carried out major interventions in currency and bond markets. The Fed completed QE2 and moved on to “Operation Twist.”

Doing the Twist involves selling short-term Treasurys and replacing them with long-dated ones. The idea is to manipulate longer-dated yields to lower levels. Many traders have jumped on the band wagon and bought long-dated Treasurys. But none of this game of smoke and mirrors changes the fundamental problems of the US government finances.

The ECB said it wouldn’t buy government bonds to bail out European governments, while buying over €200 billion of government debt.

The Bank of England continued its policy of ultra low interest rates and QE – printing money to fund the British government’s huge fiscal deficit.

Even the Swiss got in on the act. The Swiss franc had tracked gold up until August. But Switzerland is a landlocked country surrounded by euro-zone nations. A strong Swiss franc means Swiss businesses become less competitive in international markets. Particularly if those markets are distressed euro-zone neighbors.

So the Swiss National Bank announced that it would no longer tolerate a further strengthening of the Swiss franc against the euro. Having risen 26% against the dollar by mid-August, the Swissie will end the year only around 2% up.

The euro is roughly 1% down against the dollar for the year, having been up 11% in early May. The US Dollar Index, which measures the dollar against a trade-weighted basket of currencies, rose 1.7% during 2011.

Was 2011 What We Expected?

At the end of 2010 I made some predictions for what we could expect during 2011. Below are some extracts, followed by some comments.

For 2011, I’d say that a bigger crisis in the euro-zone has the biggest probability. But problems in the US and Japan are likely to follow. If either economy finds itself plunged into a sovereign debt crisis, it will be very bad news indeed. But just imagine if they all go down within a year or two of each other? Gold would be practically the last refuge for investors. Expect the gold price to skyrocket under such a scenario.

The euro-zone was indeed the worst affected by the debt crisis this year. But the story there has a long way to run. I expect the euro-zone crisis to deepen during 2012. And there is a very real chance that one or more countries will default on its debts and leave the euro.

There is also a very real chance of a full-blown banking crisis and credit crunch. This could start due to the banks’ exposure to sovereign debt and rapidly spread due to the banks’ exposure to each other.

If large banks in Europe start getting into serious trouble then there will be a global banking crisis. Large banks are highly interconnected. That means US banks could get dragged into the fray. Plus, there is the great unknown of the derivatives market, which makes banks highly leveraged and interconnected.

There is a view being touted around that US banks are safer than European ones because they are less leveraged. I believe this view is wrong.

The apparent differences in leverage are due to how financial derivative exposures are accounted for on opposite sides of the Atlantic Ocean. When you adjust the accounts so that US banks are shown the same way as European ones, they are just as over-leveraged. A major part of the global banking system is a house of cards, in other words.

Japan is edging slowly towards the abyss. The country has an ageing and shrinking population. The day when net saving turns to net spending is getting closer. At that point, who will fund the Japanese government’s huge borrowing requirements?

If Japan can’t keep refinancing its debt, it’s a big problem for the rest of the world. Japan is still the world’s third largest economy and 66% bigger than fourth placed Germany.

Headwinds Build for the US

The US got off lightly in 2011. This was because global investors had a lack of alternatives. Money fleeing other parts of the world propped up US stocks, bonds and dollars. But the fundamentals remain poor.

Corporate earnings growth is weak. Profit margins are likely to fall from record levels. Stock valuations are relatively high against a backdrop of low economic growth. And public and private debt levels remain a huge burden.

Are Treasurys Heading for a Fall?

The US federal debt continues to expand rapidly. And Washington continues to rely mainly on foreign lenders to fund its spending. But the biggest buyer of Treasurys over the past decade, the Chinese, stopped adding to their holdings in 2011.

If investment portfolio buying of Treasurys reverses at any point, further rounds of QE will be unavoidable. The dollar has been strong in the second half of the year. And this could even continue during 2012. But the long-term trend is DOWN. Creating money ex nihilo is still the path of least resistance for politicians and central bankers.

I still see the risks in Japan and the US as being significant. And it still concerns me greatly – just as it did at the end of last year – that we could see financial crises erupting simultaneously across Europe, the US and Japan.

Add these places together, and you have 58% of the world economy. Imagine their financial systems all in meltdown at once. It’s impossible to predict the outcome of such a potentially chaotic scenario, which is why we need to stay diversified. The aim is to preserve wealth, whatever is coming down the pipes in the next few years.

A Turnaround for the Emerging Markets?

Another thing I said a year ago:

Set against this backdrop I see emerging markets as being relatively low risk. That’s not to say they won’t be affected by a crisis in Europe, the US or Japan. (Or that they don’t have certain problems of their own, such as rising inflation rates and possible asset price bubbles.)

But given the generally low government, corporate and personal debt levels in the emerging markets, they remain much more attractive than developed markets at the current time. Bill, Chris and I will continue to seek out targeted investments in attractive countries and sectors selling at bargain prices. This deep value approach is one way we can significantly reduce our risk exposure in the coming year.

Stock prices have fallen in most emerging markets this year, as exported inflation became a cause for concern and investors have rotated out of what they saw as “risky” assets.

This has dragged down the prices of most of our recommended stock market investments. But I stand by these statements that I made at the end of last year.

I don’t define “risk” as short-term price moves. I’m interested in the long-term outcomes. And our own investments in emerging markets are all deep value plays. Either they trade well below their net asset values or well below (growing) cash earnings. Across the portfolio, these discounts will reduce over time.

Commodities Have Been Mixed

I also made the following prediction about commodities prices:

Meanwhile, commodities prices will most likely keep climbing as money sloshes around the world, unencumbered by positive real interest rates (interest rates above inflation).

Yes and no.

Industrial metals and agricultural commodities are generally down. Commodities indexes – such as the S&P GSCI and the Rogers International – are between 4% up and 8% down on the year, depending on their weightings to different commodities. In general, they rose until May and then fell after that.

Oil prices remain strong. The spot price of Brent Crude, the international benchmark, was up from $92.23/bbl to $107.54/bbl – a rise of 15.3%. This strength is remarkable given sluggish global growth. So far, emerging market demand growth is outweighing developed market demand destruction.

Gold: An Emerging Markets Story

And gold has continued to rise during 2011, although the price has been relatively weak recently. Gold started the year at $1,410/oz and is $1,569/oz at time of writing – a gain of 11.1%. But this is far from the peak reached on September 5, when gold briefly traded above $1,900/oz.

I expect gold to continue its bull market during 2012, priced in dollars. As explained in my last weekly review, the gold market is driven by pent up demand in large emerging markets and central bank buying. Continued financial distress could provide an additional boost at any time.

Put another way, big emerging markets such as China and India are largely driving the long-term secular bull market. US and European investor demand is largely responsible for short-term moves. It’s the longer-term trend that mainly concerns us.

Silver: Still Too Volatile

We have not recommended an allocation to silver in the Family Wealth Portfolio. But this is a market I watch closely.

Back on April 15, when silver was on a charge, I explained why we were staying away from silver. At that time the gold price was $1,481/oz and silver was $42.65/oz. That meant the gold-to-silver ratio was 35 times – the most expensive silver had been relative to gold since 1983. And the ratio had been as high as 84 as recently as late 2008, when prices crashed.

Since silver is an industrial metal, and the global economy was weakening, I reckoned there would be a better entry point.

As I type, gold is at $1,569/oz and silver is at $27.95/oz. So since April 15 gold is up 5.9% whereas silver is down 34.5%. In fact, silver peaked at $48.45/oz on April 30.

That means silver is down 42% since its peak. Gold has fallen 17% since peaking for the year. And the volatility of silver is high at the moment. Just today the price is up 4%, at the time of writing.

Put another way, the gold-to-silver ratio has risen to over 56 times (silver has become significantly cheaper relative to gold). You can see how this ratio played out on the two-year chart of the gold-to-silver ratio below.

In April I said:

I wouldn’t be at all surprised to see the gold-to-silver ratio back above 60 or 70 within a year.

We’re now getting pretty close to that point. I’ll keep watching silver. It could be something that we add to the portfolio in the coming months, especially if we get another market crash.

Stock Markets Could Fall Further

Here’s what I had to say about stock markets at the end of 2010:

High multiples mean there’s a good chance markets will correct significantly. I wouldn’t be surprised to see world stock markets correct by 20% to 30% in 2011…perhaps even more.

And on February 11 we acted on this by reducing the recommended allocation to stock market investments in the Family Wealth Portfolio from 25% to 20% and increasing cash from 30% to 35%.

At this time, the MSCI World Index had risen 4.8% since the start of the year. It peaked on May 2 – up 9% since the start of the year. The index is now down 9% for the year.

Judging by feedback we received from members, this switch out of stocks and into cash was highly controversial. This was especially true given that we already had a high allocation to cash. But we sidestepped significant volatility and price falls in equities as a result.

The surprise for me has been that stocks haven’t fallen much harder, given all that has gone on during the year.

US stocks have fared much better than many overseas markets. The MSCI USA Index is down just 0.8% for the year. The MSCI Europe Index is down 16% (measured in dollars). And the MSCI Emerging Markets Index was worst hit – down 21% for the year. (The MSCI World index has a large allocation to US stocks. So it has been held up by the relative strength there.)

We are out of European stocks completely. But we are also largely out of the US and heavily into emerging markets. And this has hurt our performance this year. (I’ll give you a full update in January once all the final prices are in.)

But we are long-term investors. And I continue to believe that long-term growth prospects are much more attractive in low debt, high growth emerging markets than in high debt, low growth developed markets.

Also, the macro headwinds that faced the emerging markets in 2011 – rising inflation and tightening monetary policy – are lessening. And emerging equities are also now trading at a decent discount to their developed peers. So I expect we will start to see a turnaround in emerging stock markets as we head into the New Year.

US Stocks: Not Cheap Yet

US stocks are even less attractive now than they were at the end of last year. Earnings growth continues to be weak or non-existent. (The energy sector is an exception.) And profit margins are at record highs and likely to fall, as they revert to mean.

Meanwhile, the dividend yield for the S&P 500 of 2.7% is low by historical standards. And the forward P/E ratio of 13.5 is not cheap, despite what many analysts claim.

The best I could say is that it could be around fair value. But even if that were true, when you combine low earnings growth with low dividends, long-term returns from US stocks are likely to be mid-single digit at best.

After inflation and taxes, the returns will most likely be negative. For long-term investments…especially investors of family wealth…this would be disastrous.

In fact, given that other stock markets have fallen much further during 2011 than the US, I’d say the US market is now exposed. Many other markets look like better value.

In general, I expect global stock markets to keep falling in 2012. We could easily see another 10% to 20% fall in global stocks – and possibly even more – during the next 12 months. But we can’t be sure. So we’ll keep our relatively low allocation to stocks for the time being.

2012: Another Difficult Year

I expect 2012 to be another difficult year for investors. Europe is deep in crisis. Japan is not far off. And the US remains reliant on foreign bond buyers and money printing to fund government spending.

As a result, I expect a lot more price volatility over the next 12 months. So we should continue to hang on to our high allocation to cash “ammo”.

It’s frustrating having to wait and difficult to know when to pull the trigger on new buys. But I expect better opportunities to pick up cheap stocks in future.

Remember, volatility is not something to be feared, but something to look forward to. In fact, the best possible outcome for us would be a major stock market crash. This would allow us to snap up some real bargains.

For now the stock market risk remains to the downside. But if I’m wrong, we still have some exposure to equities.

Gold: A Good Time to Buy?

With the uncertain macro backdrop, gold retains its appeal. The gold price has been weak recently. And 2011 is set to be the worst price performance for gold since 2008, measured in dollars.

But emerging market private and central bank buying…combined with developed market financial distress and money printing…should continue to support gold prices.

If you are still building your gold allocation, it could be a good time, with the price per troy ounce in the low to mid $1,500s.

Our Asset Allocations: Steady as She Goes!

There are no changes to the portfolio allocations recommended for now. But it pays to review your own portfolio at least once a year. You don’t need to have exactly the target allocations. But if you are more than 5% away from your asset allocations, you should bring them back into line.

Keep in mind that our recommended asset allocations are only guidelines. Your own allocation will depend on your personal circumstances – such as whether you own private businesses or how much money you have tied up in your main home.

But let’s say you agree with our recommendation to have 20% of your wealth in gold. You add up all your assets (less any mortgage debt on real estate) and find that you have over 25% in gold. In this case you should consider trimming the position.

Or let’s say you want 25% in cash. But earned income, inheritance or stock dividends during the year, have brought this up to 35% of your wealth. In this case, you should take 10% out of cash and reallocate it across any other asset classes that are underweight against target.

For example, you could add to deep value stock positions if you found that 15% or less of your wealth is now allocated to stock market investments. The point here is to stay diversified and not let any asset allocation become too big.

We continue to navigate stormy investment waters. I don’t expect large profits in the short run. But the long term is a different story…

I want to take this opportunity to thank you for your support in 2011.

As you know, Bonner & Partners is a very personal project. Our aim is to help you and your family hold on to wealth and grow it over generations. We believe this mission is now more important than ever. And it is something we are fiercely committed to.

We have taken some knocks in 2011. And no doubt there will be more to come. But together I am convinced we can ride out the current storm with our wealth…and our families…intact.

The very best to you and yours in 2012.


Rob