2012 Outlook: Uncertainty about Growth and Debts
Following a fairly quiet beginning of the year, the second half of 2011 saw wide fluctuations and jittery markets. The predominant theme was the European debt crisis, which - despite several 'ultimate' solutions - has still not been solved. Hence, the politicians have still not managed to convince the financial markets that they will be able to - or willing to - take the necessary steps to solve the crisis. Hence, 2011 will end with pronounced falls in interest-rates, expect for the debt-ridden countries, as well as negative returns, particularly on European equities. Following 2010, which was an extremely good year for investors, we have to say that 2011 offered major challenges.
If we look to 2012, we still expect that the European debt crisis will be the dominant theme for the financial markets - and we fear that the crisis will become worse before we again can look to a brighter future. Due to the focus on tighter fiscal policies and on banks that have to trim their balance sheets, growth particularly in Europe will be affected severely - but there will also be global effects. Global growth has slowed down - while emerging markets (EM) still offer the positive growth story. On the whole, we still underweight risky assets across our portfolios - and await more drastic initiatives to solve the debt crisis.
2011: year of the bonds
As appears from figure 1, particularly the second half of the year was challenging and offered wide fluctuations for investors.
The absolute top performers of the year were developed-market bonds, which - with yields falling by more than 100 basis points in the safe countries such as Germany, Denmark and the US - offered returns in excess of 10%. Equities yielded sizeable negative returns - and despite the better ‘structural story', EM equities, together with European equities, fell most. In 2011, the euro weakened by about 2.5% against the dollar, which benefited Danish investors a bit.
2011: Debt crisis - still a heavy burden
As stated above, the European debt crisis has been the key theme in 2011 - and we do not expect that it will be solved in the near future.
Global economic growth is slowing and there is widespread uncertainty about the growth outlook. The debt crisis in the euro zone troubles the global economy, eroding business and consumer confidence and hampering growth.
It is still up to the European politicians and the ECB to solve the debt crisis. We still expect a political solution and that a euro collapse is avoided (see also: Global Economy: Debt disease troubles global economy of 8 December 2011) - but the risk of a rather chaotic outcome is definitely there.
The crisis persists with varying intensity - yet no solution in sight
One of the major themes for us over the past years has been the high debt levels in the western world - primarily on the part of consumers but, particularly after the financial crisis, also on the part of a number of states. In 2011, the financial markets really focused on these problems, not least in relation to the so-called PIIGS countries, which resulted in steep increases in the bond yields of these countries (cf. figure 2).
As appears from the figure, the crisis moves on with varying intensity: The markets press for a solution; the politicians try to come up with something that can calm down the markets; this will work for a brief period - and then the markets press for a solution again.
Hence, the European politicians have not yet succeeded in convincing the markets that a solution will be found - and the therefore the fate of the global economy is very much in the hands of the European politicians and the ECB. We still expect a political solution to the debt crisis and that the ECB will play a more aggressive role. It does, however, seem that the politicians have not really understood the seriousness of the problem - and we still fear that the crisis will have to become worse before necessary and difficult decisions will be make.
But a final solution is far away. This will require much tighter economic and political integration, which is a lengthy process that will take years, cf. page 4: The euro: make or break!
Better prospects for the rest of the world
Because the debt crisis is still raging, we expect the euro zone to scrape through 2012 with recession in the quarters around the turn of the year 2011/2012. US growth looks set to be somewhat better although still lukewarm. So far, the US is fairly unaffected by the misery in the euro zone despite its high debts and large budget deficit as well as, and not least, the very negative political environment when it comes to finding solutions to the US debt problems.
In emerging markets there are large regional differences with growth in Eastern Europe being hit hardest by the debt crisis in Europe while Latin America looks somewhat robust and will benefit from the improvement in the US. In emerging market Asia, which makes up two-thirds of emerging markets, the growth signals are moderating and there are prospects of slower, yet still robust growth.
The big fear: the crisis is spreading
One of the major concerns in respect of the debt crisis is still that the crisis will, to an increasing degree, spread to the more important euro countries. While the debt of Greece, per se, is not any bigger than it can be handled, it is a totally different story if the market loses confidence in larger and more important euro countries - such as Italy (the world's third largest bond issuer) or France.
In 2011, we saw the first early signs of Italy, in particular, being involved in the crisis - cf. figure 3 showing the development of the so-called CDS's for Spain, Italy and Portugal. As appears, in 2011 it became somewhat more expensive to insure against bankruptcy, also in Italy.
There is no doubt that if the crisis spreads considerably, this may be the first step towards an even deeper crisis for the euro - and if the politicians do not succeed in convincing the financial markets that a credible solution will be found to the debt crisis, there is a risk that the European Monetary Union will collapse. The costs relating to such a collapse - and the consequences in the markets - are most severe. As stated, this is far from being our main risk scenario, but it is a risk scenario that one has to bear in mind.
Pleasant growth surprises and action by the ECB
There is of course also the possibility that 2012 will be more positive than we fear. Despite the recent more positive indicators from the US, we still see the risk for global growth to be mainly to the downside.
The joker in the pack with respect to a pleasant surprise seems to be the actions of the European politicians and not least that the ECB becomes a willing large-scale buyer of government bonds from the debt-ridden countries. This may give a confidence boost that will lift the economy (at least for the short term) and the sentiment in the financial markets.
Asset classes in 2012 - out of Europe and into the US and emerging markets
The equity market in 2012: low growth and low equity returns.
The equity market is facing an unpleasant cocktail of slower growth and unsolved debt problems in Europe. Accordingly, we generally believe that at index level investors have no prospects of high returns next year.
Despite a generally difficult development of and situation for the national budgets, businesses have been able to raise profits over the last few years. But analysts' expectations of earnings in 2012 are too high given that we face slower growth and since the earnings level is already high.
The good news is that to some extent investors have prepared themselves for a negative earnings trend by sending down prices since summer 2011. Jyske Bank expects moderate global returns in the level 5%-7%. But there is considerable uncertainty associated with this estimate both to the up- and downside. Continued major and unsolved economic challenges may result in a collapse of equities if everything goes ‘the wrong way'. But the likelihood of this is very small. In the positive risk scenario, with a minor likelihood, a dollar appreciation may lift equities markedly since an appreciation of the dollar may mean a significant improvement of the competitive power for the relatively cyclical European businesses which at the same time have a relatively high export share. However, it is crucial that a strengthening of the dollar does not take place as a function of increased risk aversion but as a 'designed' weakening of the euro.
Where do we expect the best equity investment opportunities to be found in 2012?
- We prefer US equities to European. The US has better growth prospects and is less vulnerable to global growth fluctuations than Europe.
- Asian equities will outperform equities from the old western countries. The Asian economies have no debt problems, have economic scope to boost growth and have a good demography.
- High oil prices still make oil shares attractive. Bank shareholders should have seen the worst. Global financials shed almost 25% in 2011 and European financials even more. However, it is still the most sensitive sector to the debt problems.
High-yield bonds in 2012 - first half with challenges then improvement if debt crisis comes under control
Corporate bonds (high yield) will in 2012 see general challenges in the form of government debt problems and slower growth.
We expect the uncertainty that we have seen in 2011 to continue into 2012. As long as there is no sustainable economic solution from the euro-zone countries that can satisfy the financial markets and the ECB, the risk appetite will be very low and this will, in isolation, lead to high credit spreads.
The high credit spreads which we are seeing in the high-yield market at the moment reflect several factors:
- an expected rise in the corporate default rate based on expectations of a recession in Europe in 2012
- investors demand a very high risk premium/liquidity premium to invest in the high-yield market. Many investors still remember the autumn 2008/spring 2009 when liquidity in the market froze completely and made it impossible to trade high-yield bonds.
Looking at 2012, we have no doubts that many negative effects are discounted in the high-yield market. In contrast to the crisis in 2008/2009, the companies' financial gearing is currently lower. We also believe that many companies are better prepared for a credit crisis than they were in 2008.
We expect that 2012 will be dominated by continued wide fluctuations - mainly in the first half of the year when the new EU fiscal compact must be adopted and the Southern European countries must refinance large loans. If the debt crisis comes under control, it may over time calm the markets and increase the possibility that the ECB will play a more active role. However, a final solution to the debt crisis is long in coming, which is why we only see moderate opportunities of the spread narrowing throughout 2012. More specifically, we expect a narrowing of up to 100 basis points for the year - but this estimate is associated with widespread uncertainty and fluctuations which will also be pronounced in the first half of the year. If this narrowing materialises, the total return will come close to 14%.
Emerging market bonds have many good qualities:
- high growth
- low public indebtedness
- scope to relax the economic policy
- prospects of better credit worthiness
Accordingly, our long-term expectations of emerging market bonds are positive
In 2012 growth is expected to weaken in emerging markets, but not as much as in 2009. We therefore still assess that emerging markets are an asset class that will come under pressure when risk aversion increases. However, there are signs that emerging market assets are no longer sold to the same extent when risk aversion increases. We saw an example of this in September 2011 when the outflow from the emerging market asset class was relatively limited.
The debt crisis in Europe is not the only risk factor for emerging markets. It is also important how hard the Chinese economy will land. Growth in more and more emerging market countries - especially in Asia and Latin America - is increasingly dependent on strong growth in China. A hard landing in China will hit commodity prices hard, which will particularly hurt Latin America.
We still expect a soft landing in China and fair growth in the US. This should support emerging market countries in Asia and Latin America. Given the prospects of recession in the euro zone, no immediate final solution to the debt crisis and banks' recapitalisation, the prospects for Eastern Europe are not as bright.
Our emerging market top picks for 2012 are Brazil, Turkey and Mexico.
Developed-market bonds in 2012 - the debt crisis keeps down interest rates
Three main factors may drive interest rates. 1) Growth prospects 2) Inflation prospects 3) Safe haven effect.
The growth prospects for 2012 do not indicate particularly high interest rates, and Europe seems to face the lowest growth grate with slightly negative growth in 2012. Inflation is not likely to be a major problem in 2012 either, due to low demand and commodity prices which have stabilised and even seen a downtrend since May 2011.
What is left is the safe haven effect which has prompted investors to abandon equities and seek towards the safer government bonds in 2011. For this reason, the 10-year German yield has almost halved since spring and bonds have become the top performer among all asset classes in 2011. This also means that if the debt crisis comes increasingly under control in 2012, the yields may rise slightly from the current levels.
However, it seems more likely that the debt crisis in early 2012 will stand the risk of getting more out of control before a schedule for the solution of the debt problems has been established. We expect European yields to maintain the same level in 12 months while American yields will be slightly higher.
Just as in 2011 the yield fluctuations will be historically high as the view of the debt problems constantly change between optimism and pessimism.
FX outlook 2012 - dollar supported
The debt crisis also plays a dominant role in the FX market and will continue to pose challenges in Europe.
Italy and Spain must both refinance their national debts, corresponding to 24 and 14% of GDP in 2012. A large part of the debt refinancing will take place in early 2012. We expect Q1 to send an important signal with respect to the more long-term survival opportunities of the euro.
European banks recapitalise, for instance, by closing their dollar lending to emerging-market countries, thus prompting higher demand for USD.
US economic indicators offered a positive surprise in Q4 2011. If the trend continues, we expect investors to extensively seek towards the US rather than Europe.
Recession in Europe increases the demand for safe havens in the FX market (USD and JPY. CHF is more uncertain, however.)
The development in China is also important. A soft landing will ensure amble financial scope to stimulate the economy, which will support risk appetite among investors. Especially the commodity currencies AUD, NZD, CAD, BRL and ZAR will strengthen in 2012.
A hard landing will imply a downgrade of economic growth and lead to sale of commodity currencies as well as strong demand for USD and JPY, in particular.
The commodity market in 2012: we hold our own
Several issues must be settled if the commodity prices after a challenging 2011 are to follow the long-term upward trend starting in 2002.
- Will the FED succeed in stimulating growth in the US?
- Will the Chinese manage to steer the Chinese economy to a soft landing?
- Will the European politicians find a market-friendly solution to the debt crisis in Europe?
We expect partial success with a euro collapse being avoided. If our expectations of a three per cent growth rate in the global economy in 2012 prove true, downward correction of prices for energy and industrial metals will be relatively short-term. With Emerging Markets as the driving force, we expect a slightly positive growth in demand for commodities. The prices will be supported by challenges on the supply side again in 2012.
We maintain our expectations of an oil price above USD 100. Major fluctuations are likely. At 6-12 months' term, we expect slightly rising crude-oil prices from the current levels. This increase is supported by expected positive growth in demand and a continued reduction of inventories combined with an ongoing uncertain supply situation.
We expect unchanged to slightly increasing prices from the current levels of energy and industrial metals. The high level of uncertainty will lead to major price fluctuations. We see the largest risk on the downside.
The status of Gold as a safe haven at a time of low global interest rates, fears of recession, debt crisis, financial instability, etc. will continue to attract investors in 2012, which will keep the price unchanged to slightly declining from the currently historically high levels.
Portfolio: risk somewhat below benchmark
In the course of 2011, we reduced the risk in the portfolios on an ongoing basis. We sold German and global equities as well as corporate bonds and increased our bond portfolios. Furthermore, we focused our equity exposure in global/US equities (where the dollar exposure offers a certain degree of protection) and in stable assets. We are now underweight in equities and overweight in bonds (see figure 5) and a risk level somewhat below benchmark (see figure 6). With the risk scenario we are witnessing on the threshold of 2012, we find that a continued defensive approach to the portfolio is justified.
All in all, this results in a risk of the portfolio which is somewhat below that of the benchmark.