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2012 Economic and Market Perspectives




Developed market economies are in the midst of a challenging deleveraging phase. On both sides of the Atlantic, political pressure is now shifting towards fiscal consolidation which is having knock-on effects on global GDP growth, unemployment rates and the banking system. The key question for 2012 is how deeply global GDP growth will be affected, especially in Europe, and whether credit market systemic risks can be addressed effectively by policymakers. The past year witnessed piecemeal approaches in Europe towards resolving the sovereign debt crisis and in the U.S., political gridlock is creating uncertainty with regards to the shape and form of long-term fiscal policy. Therefore, while we seek to be nimble, we maintain an overall cautious approach to our 2012 investment posture. Moreover, as we expect risk-free rates to remain low, we have a bias towards income generating instruments such as MBS, MLPs, preferred shares and large-cap dividend paying equities e.g. in healthcare, utilities and telecoms.  

On the U.S. employment front, recent declines in unemployment are largely explained by labor force contraction as certain individuals have given up seeking employment. Consumers have been facing declining net wealth and have also been drawing down on their savings. Deficit spending and government transfer payments have supported nominal income growth since 2009 and have also cushioned the impact of private deleveraging. However, this has been achieved at a price i.e. an expansion of government debt/GDP. Thus, the short-term concern for consumer spending (71% of GDP) is whether the current payroll-tax cut and emergency unemployment benefits will be extended into 2012. Therefore, the key challenge next year is whether the U.S. economy will experience the necessary employment and income growth that will support consumer spending. Moreover, from a sector perspective, we are cautious on consumer discretionary and we continue favoring dividend growing securities in the consumer staples sector that offer steady ROE (return on equity).




On a more positive note, we believe the housing market is in a bottoming phase. As we can see below, record homebuyer affordability and elevated rent prices are likely to put a floor under home prices. In addition, due to demand for multi-family units, overall housing starts and building permits appear to have bottomed. Excess home inventory will take a few more years to be unwound but in the medium-term it seems likely that households will start worrying less about further declines in their net worth. Moreover, stabilizing housing prices are supportive for our asset allocation in MBS.




With regards to broad U.S. economic activity, although Q4 2011 is likely to be seasonally strong, we are cautious on the 2012 GDP growth outlook. As we can see below, thus far the U.S. economy has been performing well versus expectations but the ECRI leading economic indicator continues to indicate a tepid forward growth outlook.





From an inventory perspective, U.S. businesses maintain fairly lean levels as judged against sales. If we consider the slack in the economy in terms of the output gap, one could argue there is further upside to inventory building and thus business spending. We have to consider though that the 2009 fiscal package (TARP) is running off and also the 100% accelerated depreciation tax credit for 2011 is running its course as well (becoming 50% in 2012). Therefore, the degree of business spending growth is likely to slow down in 2012 especially as the 2012-13 fiscal outlook tightens and a potentially deep recession in Europe may have a larger than expected knock-on effect on the U.S. and global economies. From an industrial sector perspective we have a preference for companies with long product cycles and large order backlogs e.g. exposure in commercial aerospace. Lastly, in the technology sector we have a preference for large-cap equities with strong balance sheets that enjoy healthy demand for corporate I.T. spending, as cash rich companies seek to improve their productivity levels.





The biggest economic risk for 2012 is likely to emanate from the challenging debt and growth dynamics in Europe. Policymakers are focusing most of their attention to austerity measures and budgetary discipline. In addition, shedding of assets (~EU 2-3 trillion) by an over-leveraged banking sector is likely to weigh on credit creation, GDP growth and also create headwinds for a demanding bank and sovereign debt refinancing schedule in 2012.




From a liquidity perspective, Central Banks have been fairly active by lowering the cost of USD funding to European banks and the ECB in particular has continued to expand the size of its balance sheet in an attempt to fend off a crunch in the money supply. Moreover, the ECB has pledged to provide unlimited 3 year loans to banks as they face challenging funding needs.  





Perhaps the more useful medium-term contribution by the ECB will be further interest rate cuts in order to cushion growth pressures from fiscal consolidation. Material devaluation of the Euro and improving trade balances against the Eurozone’s main trading partners can help cushion recessionary pressures and provide confidence in the servicing of government debt. The risk to this scenario is competitive currency devaluations as nations try to defend their own growth outlooks. Therefore, Europe is still a big concern going into 2012 and financial markets are likely to experience further episodes of volatility.




The third area of interest into 2012 is China, the outlook for emerging market growth and any potential side-effects impacting the energy and material sectors. Emerging markets have been battling inflation pressures in the past year but as global growth and inflation ease, central banks are likely to loosen further their monetary policies. The question in 2012 is to what degree may Chinese growth be impacted, as Chinese infrastructure and property spending slows while China’s 2009 stimulus fades. In addition, as Europe is China’s biggest trading partner the question is to what degree Chinese exports are impacted. Easing energy and commodity prices would be beneficial to emerging markets and would enable a subsequent cyclical leg in emerging market growth. On the energy front, elevated geopolitical risk from the Middle-East and stubbornly high oil prices may cause further inflation headwinds for emerging markets. Thus, the outlook for emerging markets is contingent on easing energy/commodity prices, the growth impact from a European recession and contingent on declining capital flows from developed market financial institutions.




In conclusion, 2012 is likely to be a challenging year and our goal is to continue to be nimble as favorable risk-reward opportunities are presented to us, due to episodes of volatility. In a low risk-free rate environment, we expect our core asset allocation in income generating instruments to continue to outperform.







Christos Charalambous CFA  

Senior Strategist




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