Outlook 2012

Economic growth is slowing but that does not necessarily mean a return to recession in 2012, say the Financial Markets Research team. Until the gloom surrounding the debt crisis dissipates, equities are set to remain under pressure.

As 2011 moves towards its close, it is clear that the global economy's recovery phase has slumped into a mid-cycle dip. Uncertainty is high and this is affecting the real economy. Developed economies are close to a mild recession.

Yet the situation as 2012 approaches isn't as gloomy as that might make it sound. A double dip is by no means inevitable. "Getting the moderate-growth scenario back on track does seem to be within reach," says Chief Economist Léon Cornelissen.

There are a number of supportive factors. Rising oil prices are no longer hampering growth. Retail sales in emerging markets are holding up. And the corporate sector—excluding the beleaguered financial sector, that is—is still in pretty good shape. "There is nothing special about a mid-cycle slowdown," he notes.

Weak economic growth in 2012
All in all, though, the outlook for 2012 is rather weak. Cornelissen thinks that the consensus estimate for global growth in 2012 of 2.9% (dollar weighted) is over-ambitious. “We believe the economic growth estimates for developed economies are a bit too optimistic given the current slowdown of the global economy,” he says.

“A lot will depend on animal spirits, though," he adds. "Hiring and investment by corporates largely depend on future expectations. And at present, there does not appear to be an obvious catalyst to set the train in motion.”

No relief from eurozone crisis in 2012
One issue in particular is preventing animal spirits from becoming more vigorous: the eurozone debt crisis. An ever-present theme over the last 18 months, the debt crisis looks set to continue into 2012—and beyond, says Cornelissen.

“The lack of leadership, as well as the absence of consensus on how to address the problems, will continue to reduce the credibility of any short-term, halfway solution that is concocted,” he observes. “The EFSF is too small and the co-ordination necessary to stop a banking crisis from spreading is not there.”

Multiple defaults are likely
In fact, Cornelissen thinks that Greece will default, probably before the end of 2011. “While providing a deflationary shock, a Greek default will not clear the air, as it will make defaults by Portugal and Ireland in the course of 2012 more likely,” he explains. “It will also put upward pressure on the risk premia of Italy and Spain.”

Cornelissen’s vision for the eurozone in 2012 is a series of orderly defaults, a strengthening of the European banking sector by the fiscal authorities, a substantial increase in the permanent safety net, and several longer-term proposals to change European treaties to strengthen political union.

That is actually one of the more optimistic outcomes for the eurozone next year. Alternative scenarios include a disorderly default by Greece. "We consider a disorderly default less likely but not impossible, due to the deep policy divisions in the eurozone, against the backdrop of a weakening economy," says Cornelissen.

Policymakers running out of ammunition
The eurozone debt crisis is not the only cloud on the horizon. Another worrying development is policymakers’ reduced ability to react to possible new problems. “With the debt picture deteriorating sharply, the scope for further budget stimulus is limited,” says Cornelissen.

Meanwhile, central banks have learned that quantitative easing measures—at least the ones implemented so far—have not been very effective in turning the economy around.

US should avoid recession
We've seen that—significant problems notwithstanding—the global economy is likely to see weak growth in 2012, rather than returning to recession. But what about the individual regions?

Of the major developed economies, the US looks best placed for 2012, though that isn’t saying very much. “We are not too pessimistic about the US: we do not expect a new recession. That said, there is no reason to be very optimistic, either,” says Strategist Lukas Daalder.

Indeed, US economic growth is stagnant, the housing market is moribund and the Federal Reserve is running out of ammunition and political support. But Daalder thinks the low interest rate environment and the declining price of commodities make a return to recession unlikely. "As long as new shocks can be avoided, the US economy should be on a 2% growth path for 2012," he says.

Eurozone is the weakest link
The picture in the US is quite rosy when compared with Europe, where a mild recession looks inevitable. The consensus estimate for eurozone growth in 2012 is 1.0%. “That leaves quite some room for disappointment,” notes Cornelissen.

But while the region as a whole is sliding towards recession, the picture across the 17-country shared-currency zone is mixed. “We believe that Germany—the region’s best-performing economy this year—will narrowly escape two quarters of negative growth, while France and Italy will not,” he says. Meanwhile, the real drag is coming from the peripheral countries.

Cornelissen cautions that any false moves by Europe’s policymakers in handling the debt crisis could easily push the eurozone deeper into recession.

Japan's prospects are poor
The Financial Markets Research team is not getting too excited about Japan’s prospects for 2012, either. Growth there looks set to be weak. The consensus expectation for growth in 2012 is 2.5%, a healthy-sounding number that is positively distorted by the spill-over effects from the post-earthquake recovery.

Underlying growth will thus be around 1.5%. "But even this sounds too optimistic," argues Daalder. "The slowdown of the world economy and the strength of the yen raise serious concerns about the external sector’s role as growth engine in 2012," he says.

That said, the domestic economy may take over as the main driver next year, especially as reconstruction spending in the earthquake-hit regions continues. “Although this will certainly support domestic spending, the offsetting risk is a tax rise in order to keep the government from being sucked into the ever-worsening debt vortex,” notes Daalder.

Relatively robust growth expected in emerging markets
Emerging markets remain the bright spot on the macro front in 2012. A handful of fundamental factors are supportive. First, developing markets do not have the government-debt and budget-deficit challenges faced by many of their developed counterparts. Second, their banking systems also seem to be less vulnerable. Third, more years of high labor-productivity gains are expected. Finally, domestic retail sales are still growing at a decent rate.

In 2010, these strengths contributed to some countries having to wrestle with economic overheating and rising inflation. "Now, though, these economies are set to slow, while inflation will be less of a threat," says Cornelissen.

All in all, growth should continue to be relatively strong in 2012. And the team remains upbeat about China. Inflation seems to have peaked at 6.5% in September and it looks set to decline gradually. “We feel that the worries about the Chinese banking sector and local governments are overdone, as long as a hard landing can be avoided, which we think is likely,” says Cornelissen.

Equities are likely to continue to struggle—for now
Overall, then, the macro forecast for next year may not be very sunny, but it is overcast rather than stormy. A return to moderate growth in 2012 is very much a possibility. And yet the outlook for equities is uninspiring, as the continuing elevated uncertainty looks set to hold down stock prices.

Some positives should offer support. Stocks look—on balance—somewhat undervalued. But such positives are outweighed by negatives. For instance, earnings look unlikely to hit their current—elevated—growth estimates. Analysts are projecting earnings growth of 13% in both 2011 and 2012. Chief Strategist Ronald Doeswijk says he's "skeptical" about that being achieved.

But the ongoing uncertainty will probably be the biggest dampener. "Equities are strongly dependant on political decisions, which are hard to predict," says Doeswijk. "As long as uncertainty remains high, sentiment will remain lackluster."

Overall, he believes that hard times for equities will continue while the debt crisis remains a dominant factor. That said, a turning point may be reached—in the final months of 2011 or in 2012—when there is more visibility on the way out from the debt crisis. "From there on, the outlook for equities should brighten," says Doeswijk.

Emerging markets is region offering the best prospects
Within equities, emerging markets offer the best prospects for 2012. Emerging stocks took a beating in the recent risk-off climate. Even so, the longer-term relative uptrend that started in 2002 continues to hold up well.

"We believe that this trend is likely to continue, thanks to the solid fundamentals in emerging economies," says Doeswijk. In addition, emerging markets equities should find some support from relative valuation levels. The price/cash flow, the price/earnings and the price/expected earnings ratios suggest an undervaluation of 10-14% relative to the broader market.

When gloom disappears, defensive stocks will lose appeal
All defensive sectors have outperformed the market in 2011, prompted by the halt in the flow of strong macro data and the intensification of the debt crisis. "When it becomes less murky, “risk-free” assets and defensive stocks are set to lose their attractiveness," says Doeswijk.

For investors worried about missing the turn from defensives to cyclicals, low-volatility stocks (or so-called conservative equities), with exposure to all sectors, are a good option, suggests Doeswijk. Low-volatility stocks lag the market only during strong rallies in equity markets. Otherwise, they bring high risk-adjusted returns.

"As we are forecasting some more years of sluggish economic growth, and as we believe stocks to be only slightly undervalued, we do not expect a lengthy, robust rise by equity markets. In such a climate, low-volatility equities can continue to shine," he says.

Real estate's prospects match equities'
As the eurozone debt crisis intensified, it was surprising that property stocks extended their 2011 outperformance. But the sector does have some evident positives. The balance sheets of real estate companies have improved, for instance. And the ratio of net debt to total assets is decreasing.

In short, the outlook for real estate isn’t hugely different from the one for equities. That is certainly the case from a valuation perspective, as there is no significant difference between the two asset classes.

"If moderate economic growth gets back on track, real estate will probably continue to benefit from its defensive characteristics," says Doeswijk. "But if the eurozone debt crisis deteriorates further, funding problems are likely to dominate real estate."

Long-term outlook for corporate bonds is promising
After the sell-off in investment grade and high yield bonds, prices now seem to be factoring in a recession. "One could argue that spreads have risen too far, given that corporate balance sheets are healthy and loaded with cash," says Doeswijk.

Furthermore, the asset class should not be as badly affected by a Greek default as it was by the surprise failure of Lehman. After all, the market has been expecting such a default for a long time.

Given the attractive valuation, Doeswijk says the team is inclined to take a positive view on corporate bonds relative to their government counterparts for 2012. "In the short term, however, we maintain our neutral view," he says. "We need more clarity on policymakers' decisions."

Emerging debt offers attractive yields
Investors have recently withdrawn money from emerging markets, both from equities and bonds. "This pattern suggests an indiscriminate risk-off trade, disregarding the relatively healthy fundamentals in emerging markets," notes Doeswijk.

In the short term, emerging debt will probably continue to be affected by the volatility and uncertainty in financial markets. Longer term, however, the asset class should provide attractive returns, based on the higher interest rates. The average yield on local-currency emerging debt is over 6.5%.

No sell-off now but government bonds' longer-term prospects are poor
The long-term yields of high-quality government bonds have set new lows for the period since 1900. Those yields suggest that bond investors are pessimistic about the potential for growth.

As such, the medium- to long-term prospects for government bonds are poor. In the medium term, there is a heightened risk of inflation, which is typically a key component in the deleveraging process after a financial crisis.

It is a different story for an investment horizon of a year, however. Inflationary risks are low, and the uncertainty surrounding the debt crisis must be taken into account. Furthermore, short-term rates are likely to remain low in 2012.

At this stage, the team maintains a neutral view on the asset class. "But as soon as the prospects for risky assets brighten, high-quality government bonds are set to enter a period of unattractive returns," cautions Doeswijk.

No break in long-term uptrend in commodities
Although commodity prices have been affected by the economic slowdown in 2011, the team believes they will remain in their long-term uptrend. That's because the segment's key dynamics will stay unchanged: capacity constraints on the supply side coupled with solid demand from emerging markets.

"As long as developed markets remain in the recovery phase of the economic cycle, the outlook for commodities is favorable: demand will rise, while the supply side stays tight," explains Doeswijk.

The risk for commodities is that the eurozone debt crisis drags the region into a severe recession, negatively impacting the fragile economies of the US, the UK and Japan. "In such a scenario, a further decline in commodity prices should be expected, albeit in a long-term uptrend," says Doeswijk.