Three resolutions to lower volatility in 2012

Making resolutions to improve one’s personal and professional life is a common occurrence at New Year’s, but what about for financial markets? Although I have tried, I have yet to be able to find a personal resolution that will reduce global market volatility.

Given that macro-economic events seemed to be among the main drivers of market behaviour in 2011, there are three parties who could accomplish this feat: U.S. politicians, the eurozone governments and China. The question remains as to whether the political will exists. China is the wildcard and as such I will spend most of the article looking specifically at what I would suggest China’s resolution should be.

U.S. federal politicians need to make a resolution to come up with a multi-year deficit-reduction plan that is credible to financial markets and investors. The current deadlock is not based on whether the deficit needs to be reduced—on that point there is full agreement. Where the politicians don’t agree is the relative contributions of spending cuts and revenue enhancements.

One side has the view that revenue enhancements must play a significant role, while the other insists that spending cuts be the main instrument. Short of a New Year’s resolution miracle, what seems most likely is that the politicians will continue to fight over how to reduce the federal government deficit for much of 2012. The ideological divide might get resolved in the November elections. Or it might not, in which case either a big push from capital markets or an unlikely dose of common sense among politicians will be necessary to find a solution.

For the political leaders of Western Europe, particularly those in the eurozone, a resolution to speed up their decision making process would be welcome. In fairness, and unlike the constant deadlock over U.S. fiscal policy, European political leaders have actually been trying—admittedly pushed by very unhappy bond markets—to come up with a solution. One could argue that each successive attempt—there have been five high-level summits focused on the problem—has been more productive than the last.

The most recent proposals, based on more centralized fiscal policy—appear to be on the right track. But, partly because there are so many parts to the puzzle, the solutions that have been proposed are of the slow, ‘grind-it-out’ variety. What has dismayed capital markets is that there hasn’t been a catch-all solution—such as the issuance of euro-bonds and/or the designation of the European Central Bank as a lender of last resort for the eurozone.

The process thus far has been a text book case of the difference between market speed, where decisions are made in seconds, and government speed, where the need for consultation and consensus stretches much decision-making into weeks and months.

European leaders must resolve to get up to market speed by devising solutions that are politically palatable which would also sooth the fears of financial markets. The benefits, such as lower yields on the bonds of countries in difficulty, would be worth the cost and effort.

The third party than needs to make a New Year’s resolution is the political leadership in China. Their resolution should be to continue reducing domestic inflation, speed up economic growth and do some things for the global economy that will be ultimately in their best interest.

China’s economic performance may be the most important global economic variable—and the most unpredictable—in 2012. Here we have the second largest economy in the world that has been growing in the range of 8% to 10% annually for a decade. By way of its large external sector it continues to have a huge influence on the global economy. Its massive trade surpluses and resulting accumulation of foreign exchange reserves have arguably been a factor in the very low level of global long-term interest rates.

China’s size, growth rates and desire for a bigger role on the world economic stage raise the possibility of its playing a hugely constructive role in a global economy that is struggling. But that outcome is far from certain, so appropriate New Year’s resolutions appear to be in order.

China is not without economic problems. Its industrial production has been falling since mid-2011. It’s year-over-year GDP growth has been trending downward for more than a year. It’s true that the 9.1% year-over-year growth rate posted in the third quarter is the envy of many countries. But it is down significantly from 11.9% in the first quarter of 2010.

While virtually every country would like to keep economic growth as strong as possible, China’s need is stronger than most because weak economic growth could raise the possibility of social unrest.

It also has another problem: inflation, which can also lead to some serious social problems. Tighter monetary policy does appear to have taken a big bite out of inflation, but those policies are also one of the reasons for slowing economic growth.

Even though government speed in China is capable of matching the speed of some financial markets, the fact of a looming leadership change in late 2012 may slow decision-making in the coming months.

Chinese concerns don’t stop at its borders. It is a country heavily dependent on exports, and while its international current account remains solidly in surplus (nearly US$58 billion in the third quarter of 2011), that is only a little more than half of the surplus recorded a year ago. Exports are up, but imports are more so. The latter trend is likely to continue, aided by a rising currency and fueled by the developing middle class. Export growth may remain soft both because the currency is rising and its two large non-Asian markets—the U.S. and Western Europe—are either growing very slowly (the U.S.) or are likely in recession (Europe). Europe has come cap-in-hand begging for some funds to help resolve its debt crisis. So far, China has resisted any direct contribution, but has reserved the possibility of investing through the International Monetary Fund. Having been a member of the World Trade Organization for a decade, the country appears ready to exert more influence on the world economy.

Chinese economic growth—and its influence on global growth—could go either way in 2012. A continuation of the slowing trend and/or a failure to contain inflation would hurt both the Chinese and the global economy. That would depress prices of commodities that are so important to Canada, as well as the external value of the Canadian dollar. However, the outcome for China might be better than that.

Here are a few resolutions for China to consider. Allowing its currency to rise against the U.S. dollar would help to quell the fires of domestic inflation and reduce trade tensions with America. A rising yuan should help reduce the U.S. current account deficit. With one move, China would lessen international imbalances that are holding back the world economy and curb domestic inflation. With inflation tamed, China would be in a position to further ease monetary policy and perhaps fiscal policy in order to stimulate economic growth.

Next, China might contribute to a solution to help end the European debt crisis by providing funds through the IMF. It would potentially gain two things: it would help Europe get back to economic health, which would be good for Chinese exports, and China would gain some of the international clout it desires.

We know that there are New Year’s resolutions that should be, but don’t get made and there are those that get made and aren’t kept. Making and keeping these three resolutions could make markets much more palatable—and less volatile—for your clients in 2012.

While the information provided may be intended to highlight various financial planning issues, it is general in nature. This information should not be relied upon or construed as financial advice. Readers should consult with their own advisors, lawyers and financial planning professionals for advice before employing any specific tax or investing strategy.

Views expressed regarding a particular company, security, industry or market sector are the views only of that individual as of the time expressed and do not necessarily represent the views of Fidelity or any other person in the Fidelity organization. Such views are subject to change at any time based upon markets and other conditions and Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.