2012 Risk List

It’s that time of year again, when Financial Review DealBook gazes into the crystal balls of analysts, investors, and the blogosphere, to foretell where the next financial markets catastrophe may lie.

The term “black swan” is now firmly entrenched in finance vernacular, indicating an unexpected event that sends markets into a tailspin. But 2011 was the year of the “neon swan”, when events that could be seen glowing radioactively still had the ability to induce panic.

The 2012 risk list marks the third time DealBook outlines the perils of financial markets. Here is the 2010 risk list; and the 2011 risk list, where a number of predictions came true.

Europe was most certainly a luminous swan and was top of the list of risks heading into 2011. A ‘persistent sovereign debt crisis” topped the list of risks heading into 2011, and rightly so. The list accurately foretold the risks of Europe’s debt crisis would spread from the periphery to the core of Europe. And, rather prophetically, it included the following line: “The growing debt burdens of AAA-rated US and UK economies has made the rating agencies increasingly anxious and debt downgrades cannot be discounted”. It added, perhaps somewhat preemptively, France may be the next country to be targeted by the markets.

But that’s about where the accuracy ends. “A sharp rise in inflation” and “A spike in bond yields” could not have been worse, or more costly, predictions: from July, US and Australian government bond yields sank to record lows and global growth fears and deflation pushed up bond prices.

A municipal bond crisis” also didn’t quite eventuate, as Meredith Whitney had foreshadowed, and while there was evidence of both “Geopolitical risk” and a “Chinese property bubble” (which also appeared in 2010), neither roiled markets.

So on to 2012, what lies ahead?

Here is this year’s list, once again sourced from analysts, brokers, investors and the blogosphere.

A break-up of the euro zone:

A downgrade of France’s AAA credit rating, or even that of Germany, shouldn’t come as a shock to markets, given the rating agencies have been foreshadowing it’s on the cards and bond spreads have largely “priced in” such an event.

So what are investors most fearful of when it comes to Europe? The anarchy and chaos that could arise if the euro zone unravels. With political tensions rising and a default of Greek debt imminent, the single currency experiment will be pushed to its limit in 2012.

If Greece left the euro it could sharply revise private sector assets downwards, crush Greek’s banks and spread to the periphery, prompting a run on the banks throughout the continent.

The ripple effect may be too difficult to contain, and too damaging to overcome.

A European bank failure:

Europe’s banks have a mountain of refinancing to get through in 2012 and their accelerated deleveraging is already impacting on global credit markets.

Others speculate that policymakers’ urgency to take aggressive steps to shore up the banking system and intervene in the government bond markets won’t be appreciated until it gets its Lehman moment – and that means a big bank falls over.

Absent of a large bank failure, the dramatic deleveraging of Europe’s banks threatens to impact the global economy as an estimated $US2 trillion is pulled out of the capital markets.

A hard landing in China:

Goldman Sach Asset Management’s Jim O’Neill predicts that there will be no landing in China – hard or soft. Rather it will travel along without interruption. That is the base case.

But a hard landing in China is prominent among investors’ lists of things to fear in 2012. Even if Chinese growth slowed to 6 per cent, the impact on the global economy, commodity prices and Australia would be felt.

It could happen if Europe’s debt crisis escalates, and if Chinese property prices plunge, crippling developers. A slowdown in China will have ramifications for its trading partners that are driving global economic growth at the moment – and no country is more leveraged to Chinese growth than Australia.

An Australian recession and house-price crash:

Global hedge funds have long been forecasting that Australians will soon get their comeuppance as a bursting housing bubble buckles the overleveraged household sector.

It hasn’t happened yet. So far Australia’s property market has defied the gloomy predictions. But they’re resurfacing again, as confidence falls and funding becomes tighter for the banks.

Australian house prices could be hit if unemployment increased to a point where it impacted the ability of Australians to service their mortgage. With tourism and retail already in a quagmire and the threat of a white collar recession looming as the financial services sector shrinks, is 2012 the year Australia is dragged into the global crisis?

Trade finance credit crunch:

BHP Billiton chief Marius Kloppers warned trade finance that commodity trading houses rely on is drying up. Europe’s banks provide about 75 per cent of this funding to the big Swiss-based trading houses, according to Deutsche Bank.

The last time the banks significantly pulled back on trade finance, in 2008, commodity prices fell sharply, and fears are rising that we may see a repeat in 2012.

An oil supply shock:

Bank of America analysts point out that this year’s uprising in Libya showed how sensitive oil prices are to supply disruption. As the country’s stock was removed from the market, Brent crude spiked by $US20.

In the aftermath of the “Arab Spring”, the oil rich Middle East is inherently unstable and further supply shocks cannot be ruled out. With tensions rising over Iran’s nuclear ambitions, 2012 could be the year the West intervenes. It is an event that would no doubt wreak havoc with global oil supply, the impact of which would be far more severe in a slow economy.

A US double-dip:

That the US could slip into recession again is once again a key concern for investors. Most were caught out when economic data showed the recovery was far more sluggish than initially expected, triggering a sharp correction in the second half of the year.

The news out of the US has been progressively better but risks remain that the recovery could turn sour. High levels of public sector debt – both federal and municipal, structurally high unemployment and the added spice of a presidential election make for an interesting year state-side.

Corporate profits shock:

The global economy is in its poorest state in a generation, yet large companies are still making good profits. A combination of exposure to growing markets, balance sheet and cost management, and an embrace of technology has ensured that despite falling stock markets, earnings are being delivered.

Big companies are the safe havens in both debt and equity markets as investors seek income. But could 2012 be the year that the pain felt by governments and households is passed on to the corporate sector?

That old chestnut – Geopolitical risk:

Yes, geopolitical risk has become a permanent fixture on the DealBook “risk list”.

Outside of Europe, the US and China, investors should keep an eye out on the “known unknowns” such as: a conflict with Iran; a nuked-up North Korea’s power vacuum; a civil war in Iraq; a break-down in US/Pakistan relations; and political uncertainty in Russia, as Prime Minister Vladimir Putin’s popularity wanes as he seeks to regain the presidency.

Elections in Mexico, India and France also provide food for thought.

A market recovery:

With all the doom and gloom in the market, investor morale has never been lower. Fewer investors have faith in the markets, as demonstrated by historically low bond yields and low price to earnings multiples in the stock market. Those lured back into the markets after 2009’s recovery are determined not to make the same mistakes again.

But have we become too afraid? What if Europe’s leaders are able to resolve their debt crisis, and the US economy mounts a recovery?

The latent fear among investors would evaporate and money would rush back into risk assets.

Those hunkered down in the basement with their shot guns, gold bars and canned food run the risk of missing an almighty rally.

Written by Jonathan Shapiro (Source from The Australian Financial Review)