If you feel in need of peace and quiet after the festive frolicking you could do worse than to move to Ciudad Valdeluz. This new city, 60 kilometres northeast of Madrid, was supposed to house 30,000 people. Its current occupants number 600. For those who bought off-plan at the height of the Spanish property boom in 2007, Valdeluz (an invented word approximating to valley of light) has turned into Valle de Lagrimas a vale of tears.
This is a diorama of the lingering economic crisis afflicting much of the developed world. Spanish banks lent more than 300 billion to real estate developers, and in 2007, loans to individuals in Spain, many to fund property purchases, were growing at an unprecedented 30% annualized rate. Many of those loans have turned bad, first infecting the banking system, then the real economy and latterly the perception of the solvency of the Spanish state and even the efficacy of the entire eurozone.
It is not just the residents of Valdeluz who are feeling unhappy with their lot this new year. Markets are determined to see the glass half-empty. On the day it was announced that Europes banks had borrowed 489 billion in three-year money from the European Central Banks long-term repo operation, equities fell.
The LTRO solves a liquidity problem when the big issue remains solvency, and the eagerness to access central bank money reflects the poor quality of bank assets and the willingness to use them as collateral. However, that does not make the ECBs actions wrong or unhelpful. With bank debt refinancing set to spike in early 2012, a potential credit seizure has been averted.
Twilight of the banks
Perhaps the most remarkable fact about the global economy in 2011 is that it grew at 3.5% despite much of the western financial system remaining highly dysfunctional. In 2012 there will be little respite in credit conditions. European banks need to boost tier one core capital by 106 billion by the middle of the year and refinance 1.7 trillion of debt by the end of 2015. Faced with a sceptical investor base, banks will continue to shrink their balance sheets, shuffle risk-weighted assets and close businesses.
It is easy to rattle off horrible things that could go wrong in 2012. But positive surprises are also possible
Unconventional tools such as the LTRO and quantitative easing have pushed central banks into the limelight as the traditional actors in the financial system skulk in the wings. Interest rates cannot full further, hence the focus on bond yields. Large corporations with direct access to capital markets can fund more cheaply and numerous credit-easing initiatives are offering support for small businesses.
In effect, banks are being disintermediated as they delever and rebuild their balance sheets. The fragility of markets reflects the untried status of the current policy prescription: engineering economic recovery in a highly credit-constrained environment. But there are tentative signs it might be starting to work.
The first economy to pull the quantitative easing lever was the US. Its growth, although anaemic, outstripped the eurozone and the UK in 2011. By flooding the system with money, the Federal Reserve has also ensured its banks are farther along the road to recovery. Most already have reasonable capital buffers in place. US growth bounced in the second half, and leading indicators, such as consumer confidence, are turning. Economists who have rushed to downgrade consensus growth forecasts for 2012 might begin to rethink, which will put a floor under US equity prices.
However, the biggest support for risky assets in 2012 is valuations. The last and only time in 40 years that the yield on the 10-year Treasury bond fell below the dividend yield of the S&P500 was the nadir of the stock market in March 2009. The markets that suffered most in 2011 are, by some measures, even cheaper now.
The Stoxx Euro 600 is down 12% and on a price/book basis is better value than the 2009 low. With the Nikkei 225 down 14%, Japanese equities are trading at less than one times their price/book ratio. With reconstruction following the devastating earthquake and tsunami in full swing, the economy should also return to growth.
Over the past decade equity investors in the US, UK, Europe and Japan have been rewarded with volatility and little else. But the alternatives are equally unattractive. Anyone tempted to buy UK gilts at current levels would do well to remember that the last time the 10-year yielded around 2% was in 1946. Bonds then lost 75% of their real value over the next three decades.
It is easy to rattle off horrible things that could go wrong in 2012. But positive surprises are also possible. A reversal in US property prices and the sub-prime debacle of 2007 were the first dominoes to fall in the crisis. US house prices continue to decline, but sentiment among homebuilders is improving, as are sales. A 1% rise in US house prices is a $160 billion positive wealth effect.