European crisis begins to ease even as Europe experiences a recession
The political and monetary authorities have moved from a position of complacence and inaction to one of irregular, but somewhat constructive action. The ultimate path to a solution is unclear, particularly given the varied interests of multiple countries and constituencies in formulating incremental fiscal union, creating the enforcement mechanisms for austerity measures, and attempting to generate economic growth are each difficult.
We believe that all parties recognise the seriousness of the crisis and will continue to take enough action to avoid an outright catastrophe. In any case, however, it seems clear to us that Europe’s problems are significant enough to drive the region into a (hopefully mild) recession in 2012.
US economy muddles through yet again
Deleveraging will continue to limit growth to a sub-par rate but recession will continue to be avoided. A strong corporate sector, improving consumer sector, and financially strapped government sector will combine to give variable but positive growth for all four quarters of 2012, resulting in GDP growth of somewhere in the 2 to 2.5% range.
China and India contribute more than half of the world’s economic growth
While growth in China and India is likely to be slower in 2012 than it was in 2011, these two countries will account for more than half of 2012 global growth. We expect increasing inflation leading to policymakers raising interest rates and/or reserve requirements will begin to reverse sometime in 2012.
US earnings grow moderately but fail to exceed estimates
The trend of surpassing expectations has been in place since the start of the economic recovery in 2009 but is nearing an end. The pace of earnings growth will slow in 2012 and will fail to exceed expectations (currently $108) for the first time this business cycle.
Treasury rates rise and quality spreads fall
At some point the world will either move into an environment where deflationary pressures justify a very low interest rate structure, or one in which deflationary risks dissipate somewhat – the latter is more likely. The ‘crisis premium’ that has kept risk assets cheap and Treasury rates low is likely to lessen in 2012, Treasury rates are likely to move somewhat higher, risk assets should perform better which would include a reduction in credit spreads of all types.
Double-digit return from US equities
Should earnings rise around 6% in 2012, and should stocks continue yielding around 2%, it would take only modest valuation improvements to reach double-digit returns in 2012. Valuations are compressed for a host of concerns, most notably the risks associated with potential European financial contagion. Strong financial health in the corporate sector should provide some support as well.
US stocks outperform non-US markets for the third year in a row
With reasonable earnings growth and attractive valuations, the US can outperform again in 2012. This will require modest economic and earnings growth compared with recession in Europe and malaise in Japan. Perhaps during 2012, emerging market equities will resume outperformance, but it is too soon to make that call now.
Dividends and buybacks hit record high
The amount of cash used by US corporations to raise dividends and buy back stock will grow by another 20% or more in 2012, surpassing the record set in 2007. Companies used cash in 2011 for a significant number of acquisitions, an activity that is likely to continue in 2012 given low valuation levels and low cash returns.
Healthcare and energy outperform utilities and financials
Healthcare should benefit from continued predictable earnings growth coupled with reasonable valuations. Energy is our cyclical choice and is inexpensive relative to its history, the overall market, and oil prices. Financials have been a significant underperformer for several years and at some point may have a rally, but probably not quite yet. We believe utilities are overvalued, especially given weak earnings prospects.
Opportunities for investors
- Shift to equity overweights
- Stick with free cash flow and dividend growth
- Focus on US stocks
- Rotate to attractive areas of the market
- Expect further divergence of returns
