The 3 Financial Shocks of 2012

Maybe 2012 will be a great year. But here's what could go wrong.

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There's a case to be made for optimism in 2012. Many bad economic problems are behind us, with the housing bust in its latter stages and consumers working their way out from under a mound of excessive debt. Most big companies are in good shape, and many Americans have learned smarter, more sustainable financial habits.

[See 11 companies on the edge in 2012.]

But a true economic recovery may still be farther away than anybody would prefer. The most obvious time bomb is the financial crisis in Europe, which has depressed the stock markets and sent many investors to the sidelines. The Middle East, after a year of revolution, may be more unsettled than it was a year ago, not less. And U.S. politicians now seem poised to do more harm to the economy than good. As smart investors ponder what 2012 might bring, here are three possible financial shocks they foresee, along with the ramifications:

Europe's "TARP moment." If you've tuned out the endless stream of rumors, communiques, and doomsaying regarding the European debt crisis, you might want to tune back in. Without a doubt, there's a mind-numbing, Groundhog Day regularity to the cycle of crisis, sell-offs, and just-in-time reassurance by European leaders. But this festering problem may finally reach a climax in the first six or even three months of 2012, with a panicky market triggering bolder political action than before—followed, perhaps, by a major relief rally.

The prevailing view is that there's only one move that can convincingly resolve the debt crisis: a huge bond-buying program by the European Central Bank, which would represent open-ended and ironclad support for the debt of troubled nations like Greece, Italy, and Spain. But the ECB doesn't want to ride to the rescue until all other options have been exhausted. "Only in the face of a seriously escalating crisis will they step in and announce a big buy of government debt," says Ethan Harris, head of North American economics for Bank of America Merrill Lynch. So it may take a near-catastrophe to provoke the one move that could actually resolve the whole problem.

[See who will struggle in 2012.]

There will still be more of the familiar dickering as politicians in troubled countries duck and weave on the kind of economic reforms the ECB and other European leaders want to see, such as wage cuts, tax hikes, and the repeal of rules that protect favored businesses. But the time for delay may soon run out.

One likely trigger that will push the crisis into its endgame is a series of failed auctions of Italian debt, which could occur in February or March, when several important auctions need to be held. The "TARP moment"—which refers to the September 2008 stock-market plunge that persuaded Congress to approve $800 billion for unprecedented bank bailouts—will arrive when European voters and politicians start to believe than an imminent financial meltdown will cause more pain for more people than tough economic reforms. If investors lose faith in Italy, for example, it will push up interest rates on new Italian debt, which in turn will raise concerns about the viability of banks throughout Europe, and undermine the whole European economy. There could also be downgrades of credit ratings of other European countries. Greece may finally default on some of its debt or leave the euro zone. The scary rumors, in other words, might finally come true.

The exact chain of events is hard to predict, but the final moment of brinksmanship will probably involve an unnerving drop in stock values. The original TARP moment, for instance, brought a one-day drop of nearly 9 percent in the S&P 500 stock index, which was already down 17 percent for the year. But if politicians finally commit to tough reforms, and the ECB then fires its heavy artillery, a sharp rebound could follow.

[See who will prosper in 2012.]

The script may not unfold according to conventional forecasts, of course, which is why it's risky to bank on an orderly solution to the problem. Political unrest could lead to a breakup of the euro zone, rather than a repair of it. European banks could end up even more damaged than expected. Or, politicians could find ingenious new ways to delay (and possibly worsen) the culminating event. Whatever happens, the fate of the euro zone will probably be clearer a year from now.

A showdown with Iran. This Mideast theocracy is another perennial worry that tends to fade into the background as more pressing events dominate the news. But Iran's quest for nuclear weapons seems likely to cause some kind of military confrontation sooner or later, and the Council on Foreign Relationscounts Iran as a "Tier 1" risk for the United States in 2012. Iran is believed to have enough nuclear material to build four or five bombs. It might be able to build actual weapons, with missiles that can deliver them, by 2015. But for a pre-emptive strike—by the United States or more likely, Israel—to be effective, it would have to come far before Iran actually fields nuclear weapons. A hard-hitting report published by the International Atomic Energy Agency in November portrayed Iran as aggressively pursuing nukes, providing legitimacy for some kind of pre-emptive action. Deeper sanctions are one option, but the case for military strikes seems to be getting stronger.

[See 10 ways spending and saving are changing.]

Complicating the matter are statements by Saudi Arabia hinting that it, too, will seek nuclear weapons if the West doesn't do something decisive to halt Iran's nuclear program. Western strikes against Iran may start to seem preferable to a nuclear arms race in the Middle East.

Since Iran is the world's third-largest crude oil exporter, a military confrontation or even tough sanctions could roil the oil markets more than anything that's happened over the last decade. During the late 1970s and early 1980s, the Iranian revolution combined with the start of the Iran-Iraq war caused oil prices to more than double. Today, that sort of reaction would send prices well over $150 per barrel, which alone would probably cause a global recession. Without an Iranian confrontation, the outlook for oil prices is generally benign. But it's hard to see how it will stay that way as Iran comes closer to nuclear capability.

Congressional ineptitude. The good news is that barring unforeseen developments, the U.S. economy won't depend all that much on political action out of Washington in 2012. The Federal Reserve, which is independent of Congress, may pursue further monetary stimulus measures if growth weakens or unemployment stays high. But by the end of 2012, an unprecedented set of economic decisions will need to be made—by a lame-duck Congress in the aftermath of a turbulent presidential election.

[See 3 holes in Obama's "fairness" doctrine.]

The biggest decision is what to do about the Bush-era tax cuts that are set to expire on Dec. 31, 2012. Sharp spending cuts—which will hurt defense and other programs—are set to begin on Jan. 1, 2013. If Congress does nothing, or can't reach agreement, the tax hikes and spending cuts set to begin in early 2013 would hurt GDP growth and possibly induce another recession. The last-minute nature of any decisions will be harmful as it is, since business leaders, wary of so much uncertainty, will delay hiring plans and risky investments until they know what's coming. And in early 2013, America's borrowing limit will need to be increased again, raising the prospect of more self-destructive brinksmanship that makes Americans even more disgusted with their leaders.

The world economy has been forgiving of the United States lately, with investors still flocking to Treasury securities, for example, despite the first-ever downgrade in the U.S. credit rating last summer. But politicians may make the mistake of counting on that largesse for far too long—as their counterparts in Europe have done. Temporary extensions won't work that much longer, either, since the rating agencies have given notice that any unexpected additions to the national debt will probably lead to further downgrades. Ultimately, there will come a crunch point at which politicians in Washington either do their jobs or wreck the economy.

There is, of course, a fourth type of financial shock that could occur in 2012: The one that nobody foresees. Another possible surprise is that things turn out to be better than expected. But these days, even being an optimist is risky.

Twitter: @rickjnewman

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