New Year 2012

The global economy continues to eke out growth despite repeated market shocks and political earthquakes. These rumblings have not been entirely costless. Several fissures have begun to form, presenting threats to the recovery. The risk that Europe goes badly off the rails has grown over the past several months. Politicians and policymakers hold in their hands the capacity to avoid this worst–case scenario, but have so far displayed questionable dexterity. Political dysfunction has damaged confidence and fiscal drags are beginning to bite. It is increasingly clear that this economic cycle is little different from recoveries that have followed financial crises in the past. Simply put, the road back to normal is invariably long and slow.

Muddle–Through Economic Scenario Still Our Base Case

The current investment environment is characterized by two divergent potential outcomes. Our base case scenario has Europe muddling its way through the current crisis. Any fix will not likely be a perfect long–term solution, but rather one that persuades markets that a collapse is off the table. We expect any recession in Europe to be relatively mild and for recession in North America to be avoided. Global conditions should remain modest but positive, buoyed by firmer economic growth outside developed markets. The alternate outcome is for Europe's crisis to escalate dramatically, with negative consequences for risk assets and further declines in bond yields.

The Eurozone has continued to deteriorate, engulfing erstwhile bystanders such as Italy, and knocking on the doors of Spain and Belgium. Unfortunately, politicians are stuck in reactive mode. They require market stress to secure the public support needed to implement bailouts. The ECB is doing a wonderful job of providing unlimited liquidity to European banks, but even unlimited liquidity has its limits when banks begin to run out of acceptable collateral. The most likely course of events for the Eurozone is that policymakers take several more months to arrive at a coherent and truly workable solution. Bouts of volatility and pessimism are probable until this proper final fix is struck.

Our models indicate that the U.S. is not presently in a recession, but is at risk of tumbling into one within the next year. The threat comes less from domestic U.S. conditions, and more from the possibility of a European misstep with global consequences. Even absent a recession, growth prospects remain uninspiring. America is still riddled with dysfunctions, and these are holding back a proper economic recovery. The housing sector remains stubbornly resistant to significant improvement, but we are increasingly of the mind that the stage is being set for a halting, modest housing recovery. The labour market is also misbehaving. Job growth now looks to be picking up moderately, but it will struggle to eat into the overhang of unemployment.

Canada continues to appear more sprightly than most. The combination of credit growth, job growth, and high and steady commodity prices are the ticket for ensuring ongoing economic gains. However, it remains highly unusual for Canada's economy to significantly decouple from the U.S., especially given the Canadian dollar's tendency to act as a shock absorber. As such, we forecast a downshift in economic growth in Canada in 2012.

Dollar a safe haven when risk aversion returns

We cannot know yet whether the U.S. dollar lows last summer marked the bottom of the dollar bear market, or whether the 8% bounce since is merely a safe–haven rally. We can assert, however, that the European crisis, like the financial–system collapse of 2008, has made it obvious that the greenback remains a safe–haven currency, and that all other currencies are secondary when risk aversion takes hold of the market. With a number of unresolved issues in Europe and critical funding needs concentrated in the first quarter of next year, the spreading crisis will eventually weigh down the euro. With regard to other currencies, the past year's 'currency impasse' characterized by volatility in foreign–exchange values without sustainability, may very well extend into 2012. We want to take advantage of the volatility and favour establishing or adding to U.S. dollar exposure during its sell–offs in the belief that the volatility will eventually be resolved to the upside.

Benign inflation and short rates remain low

Global inflation is still a bit high due to the lingering effects of higher commodity prices from the spring of 2011, but this influence is rapidly ebbing. The likely trajectory for inflation is down to normal, or even sub–normal, levels given the substantial global economic slack that persists. The modus operandi for the world's central banks remains to keep the pedal to the metal. For countries like the U.S., the U.K. and Japan, this means unchanged policy rates since their accelerators are already pressed against the floor. European Central Bank President Mario Draghi seems more willing to deliver monetary stimulus than his predecessor, likely translating into further policy easing in the coming months.

Significant upside risks to bond yields

Most major countries continue to enjoy near–record–low bond yields despite the unfolding crisis. The reasons that yields remain so low are simple: the short end of the yield curve is being pulled lower by stimulative central banks, and investors chasing yield have compressed the premium required for holding longer–term bonds. Growth prospects are limited, constraining the real bond yield, while inflation looks to be mostly contained, holding down the inflation component of the yield. Elevated risk aversion is boosting demand for bonds, and several central banks are actively engaged in quantitative easing, creating an additional major source of demand for their own sovereign bonds. The combination translates into extremely, and persistently, low bond yields.

It isn't clear how long this perfect storm depressing yields will last. It will be hard for yields to move sustainably lower from here unless the feared collapse of the Eurozone becomes a reality, whereas the scope for eventual increases is much greater as the crisis fades and growth in Europe resumes. We do not need a "solution" to Europe's crisis to drive yields higher. Rather, a "fix" that allows progress would be sufficient for bond yields to begin their return to normalcy.

Equities struggle to look beyond crisis

Global equity markets have exhibited unusually high volatility since mid–summer. Periods of optimism have been followed by offsetting periods when fear and risk aversion have dominated. Equity investors have been forced to balance this near–term uncertainty against historically attractive valuations, and at times, uncertainty has won out. During this period, equity markets have been trading in a well–defined range. Our view remains that it will be difficult for stocks to rise above the top end of the recent range without a significant breakthrough in the European sovereign–debt crisis. Similarly, equities are unlikely to decline into the bottom half of the range unless we see an intensification of the various crises confronting the global economy, an increase in the risk of recession, or falling profits.

While markets have recovered since early 2009, valuations remain attractive. Today's depressed P/E multiples suggest investors are sceptical earnings growth can be sustained given the risk that Europe's fiscal crisis will trigger a broader recession. With the benefit of hindsight and sustained economic growth, and the restoration of investor confidence, these valuation levels may one day seem outlandishly low.

Corporate profitability and fundamentals are extremely healthy. It has been well documented how aggressively firms cut costs during the 2008–2009 financial crisis, and how reticent they have been to resume hiring as growth recovered. This caution has helped direct a near–record share of each dollar of sales to the bottom line. There is little to suggest that purse strings will be loosened appreciably in the near future, and so as long as modest growth prevails, margins should be maintained and overall earnings can continue to rise.

Asset mix — modestly overweight stocks, underweight bonds

While risks to growth are easy to enumerate, a durable solution to Europe's fiscal crisis is a work–in–progress that should, over the coming months, provide investors with greater certainty that a worst–case outcome will be averted. Today's extremely low yields on U.S., Canadian and U.K. government bonds will be difficult to sustain in any environment that includes modest economic growth and progress toward crisis resolution. We are also closely monitoring evidence that the global economy is still expanding at a decent pace. This, too, will help confidence recover. As that happens, bond yields will likely rise from current ultra–low levels and result in capital losses for bond holders. Given this view, and its implied risk of higher bond yields, we remain underweight fixed income. Within equities, we are maintaining our modest overweight position. Although growth next year will remain weak, severely depressed equity–market valuations provide upside potential. As long as growth is sustained, normalizing valuations will ultimately drive future returns. However, our overweight stance is relatively modest in recognition of the fluid situation in Europe and unusually wide divergence between the potential outcomes of the crisis. For a balanced global investor, we recommend an asset mix of 57.5% equities (benchmark: 55% within an allowed range of 40% to 70%), 35.0% bonds (benchmark: 40% within an allowed range of 30% to 60%), with the balance of 7.5% in cash.

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