There are still four major problems facing investment

Despite positive steps undertaken by various governments and the ensuing recent correction in markets there remain four serious threats to investment.

The first is earnings disappointments in 2013. The second is the impact of the so-called “fiscal cliff” which could throw the US economy into recession. The third is the break-up of the EU in spite of the best efforts of the leaders. The result of this would be widespread defaults on the sovereign debt of some of the weaker countries, creating havoc in parts of the world banking system. And the fourth is the risk of an Israeli strike on Iran.

Taking them in order, the prospect of a decline in S&P 500 operating earnings in 2013 from 2012 levels is real. Profit margins as a percentage of sales are peaking at about 9 per cent and corporate profits as a percentage of GDP have risen from the long-term average of 7 per cent to more than 10 per cent today. During the first three quarters of 2012, the US economy grew at a real rate of less than 2 per cent. Growth should pick up in the fourth quarter to something better than that, but hardly to a level that could be described as a strong economy. At the current rate of growth the US doesn’t do much better than absorb the new people coming into the workforce.

Almost all strategists are forecasting an increase in S&P 500 earnings next year. From this year’s probable level of $100 (Dh367) or more, most believe 2013 will come in at $105–$110 (and there are some bottom-up estimates above $120). The world is a very competitive place and few believe that GDP in the US will grow as much as 3 per cent next year. The slowdown in Europe will have some impact on US exports. Moreover, companies have limited pricing power, and inflation (modest), is still pushing some raw materials prices and other costs higher. So if revenues only increase by a small amount and costs rise, there is a good chance margins will be under pressure in 2013, raising the possibility of earnings disappointments. We have already seen a hint of trouble coming: in the second quarter more than half of all S&P 500 companies had sales realisations lower than forecast.

Tax preferences

If S&P 500 earnings were flat, the market at 14.5 times 2013 would still be reasonably priced. The prospect of another year of double-digit S&P 500 appreciation, as we have enjoyed this year, would seem unlikely, however.

Both in the political arena and in investment management conference rooms, the prospect of the “fiscal cliff” is giving rise to a great deal of discussion. The largest component of the fiscal cliff is the expiration of the tax preferences enacted under George W. Bush, which amount to more than $300 billion. While President Obama would eliminate the cuts for those making over $250,000 and modify the dividend and capital gains rate, it is unlikely that even he would let all of the Bush tax cuts expire. Other provisions like the payroll tax relief and the sequestering of funds for health care, defence and other items that resulted from the inability of Congress to come up with a workable plan to cut the deficit last fall are likely to be deferred temporarily. The task facing the government in Washington is a tough one. They want to cut spending programs and they want the economy to grow at the same time, but government expenditures contribute significantly to that growth and if Congress cuts too much, it may imperil the expansion of the economy. We are facing a potential crisis and Washington will have to respond to that challenge.

Virtually all the policy makers in Europe seem to be trying to work together to find a solution to the sovereign debt problem. Monti of Italy, Rajoy of Spain and Hollande of France have met to discuss sensible approaches to deficit reduction. Merkel of Germany has met with Samaras of Greece to show her support. There is a growing realisation that if any major current member of the EU were to default on its sovereign obligations, Europe’s fragile banking system would be in trouble.

The solution, if there is one, is for the ECB to continue to provide liquidity to the banks and to the governments themselves and to require those countries receiving funds to meet certain financial conditions in exchange. The next step is for the various countries to move toward some form of fiscal convergence. The first phase would be a banking union with a deposit insurance programme. Next would be the establishment of some central authority to assess the ability of each country receiving aid to meet its deficit targets. Everyone agrees that a political union in Europe is probably impossible, but a greater degree of fiscal cooperation is likely.

Israel strike unlikely

Finally there is concern around the world that Israel will strike against the nuclear development facilities in Iran, with or without the help of the US. Iran would undoubtedly retaliate heavily against Israel with its missile capability although it is not clear how much damage would result if the missiles are not intercepted. The entire region would be destabilised and the price of Brent oil could rise to $200. As a result, both Europe and the US could move into recession in 2013.

I believe a strike by Israel is unlikely, and over the last month some developments have taken place, that could bring Iran to the negotiation table. There is evidence that the sanctions imposed on Iran are starting to hurt the Iranian economy seriously. The currency has depreciated by 40 per cent, inflation is becoming virulent and social unrest is erupting into a major problem. There is a report, unconfirmed by both sides, that the Iranian government is willing to engage in one-on-one talks with the US and others. This would be good news true, although a favourable resolution of this situation is likely to be slow.

Sabotage and assassinations have slowed the nuclear programme down, and some intelligence sources say Iran is not close to having a bomb. Syria, an important ally of Iran, is under siege and the regime of Al Assad could fall at any time. As Iran becomes increasingly isolated and social unrest becomes a continuing problem, its leaders may be more willing to negotiate a redirection of its nuclear project away from weapons production.

These are my worries. Any one of these issues could seriously darken the prospects for 2013. I have had an optimistic view of the US in 2012 and the market has appreciated more than most observers expected; the events described here could make 2013 a more difficult year.

Byron Wien is Vice Chairman, Blackstone Advisory Partners LP