With the U.S. growing at an anaemic level, and Europe balancing on the brink of recession, we are yet to see signs of meaningful recovery from the global financial crisis. Negative headlines continually rattled the markets with few positives to cheer about, except for perhaps resilient corporate earnings and moderating inflation. We think in 2012 every basis point of return will be hard fought. Regional diversification will need to be firmly in place, as the economic centre of gravity will continue to shift eastward. As returns from traditional investments remain flat, alternatives will rise in importance and volatility, while certainly causing market stress, will also bring opportunities for dynamically-managed portfolios.
On a positive note, we think 2012 will see some improvement in economic growth in the U.S. Our central forecast, predicated on Europe avoiding a full-blown financial meltdown, is for 2.5% GDP growth compared to 1.7% this year. Nonfarm employment gains are projected to reach a plateau level between 190,000 and 200,000 jobs per month in mid-2012. This would be better than in 2011, but with the labour force naturally increasing by about 150,000 people per month, the unemployment rate is not poised for a sharp drop any time soon.
Inflation expectations in the U.S. and the developed markets appear to be more firmly anchored around 2% than they were at the start of the year, when speculative bidding and political events in the Middle East drove up commodity prices. Next year, Libyan oil exports will probably come back online and the supply-chain problems that followed the disastrous tsunami in Japan will likely be resolved. Unfortunately, the most serious impediment to a strong 2011 – lack of political clarity regarding the European and U.S. debt problems – is set to continue in 2012.
Call this continuous policymaker injection of uncertainty. In fact, policymakers never missed an opportunity to inject uncertainty in 2011, as they raised expectations for definitive measures and then continually fell short. The August 2011 debt ceiling debacle, followed by the do-nothing budget Super Committee in the United States Congress and, more importantly, the European Big Bazooka proposals to resolve the crisis in November 2011, clearly failed to contain market jitters.
A European recession seems inevitable in the first half of 2012 but Europe's leaders can still act to prevent financial collapse and a deeper downturn. We believe they will. Given the heterogeneous nature of economic conditions across the European region, it is not easy to set GDP growth forecasts. However, we think that in the event of a political resolution to the sovereign debt crisis core Europe should at least return to positive – albeit very weak – growth by the end of 2012.
We imagine a political solution to the European debt crisis as a "three-legged stool". The first leg would be a central fiscal authority with much more financial firepower than the current arrangement . The second leg would take into account that investors have lent more money to European peripheral countries than can reasonably be expected to be paid back; therefore, some debt restructuring will be required. The third leg recognises that peripheral countries, if they wish to remain in the Euro-zone, need to reform their economies to become fiscally sustainable as well as internally and externally competitive with core countries. Supporting the three legs, the deep pockets of the European Central Bank will need to be tapped to shore up illiquid, but inherently solvent entities, be they countries or banks. Our guess is that one way or another this pivotal issue confronting financial markets in 2012 will have to be resolved quite soon. Spain, France, and Italy alone require close to €650 billion in new funding in 2012, much of it early in the year, as previously issued debt needs to be retired. European banks are estimated to require a further €144 billion in short term funding in 2012. The current state of half-measures cannot linger deep into 2012, based on arithmetic alone.
For Asia-ex-Japan, 2012 will be a year of dealing with external threats after dealing with the internally generated threats of inflation and overheating in 2011. The main danger for 2012 is a significant slowdown in export demand as Europe slides into recession. This could be exacerbated by tighter credit conditions as European banks restrict lending to maintain capital ratios. The positive news is that inflation appears to have peaked across the region. China, in particular, has scope to significantly ease monetary conditions. We see a gradual economic slowdown in China with downside risk to the consensus forecast for 8.5% 2012 GDP growth. China's central bank has already started easing monetary policy and will likely to continue easing in early 2012. With attractive share market valuations, Asia-ex-Japan has potential for strong outperformance once the crisis in Europe is resolved.
Japan's share market looks cheap and could be ready to outperform, but we have little confidence in the ability of the Japanese economy to generate sustained growth. Yen strength is a significant problem and attempts so far at currency intervention have been feeble as the Yen continues to be perceived as a safe haven currency. Having said this, the rebuilding process from the tsunami will provide a significant boost to economic activity and Japan is likely to be the only major economy to post above trend growth in 2012.
Circling back to our 'every basis point matters' theme for capital market returns, we project that given all the risks, the U.S. S&P500 share market index has the potential to provide solid if unspectacular returns (high single digits) over the next 12 months. Likewise, Asia-ex-Japan equities markets have potential for outperformance in 2012. Until a sustainable and credible solution is found for the Euro-zone, we recommend defensive positioning in European equities. In bond markets we project that the benchmark 10-year U.S. Treasury yield will end the year noticeably higher (moving toward 3%). Bund rates will remain low as long as investors continue to see them as a safe haven.
Making gains this year will require an active, global, multi-strategy approach and identifying outperforming managers in every sector and region will count more than ever. Gaining access to non-traditional securities through alternatives will also be a key potential return enhancement strategy. Volatility is here to stay, but a dynamic approach to investing will make it possible to take advantage of opportunities as they arise.
