The latest rating downgrades to various European countries & its bailout fund itself are a reminder the European crisis is continuing. However, the downgrades tell us nothing new – indeed European shares actually rallied after the news. Moreover, I was determined after writing endlessly about Europe last year that my first note this year would not be on Europe. In fact, this note takes a different tack to normal Oliver’s Insights. Having just gone through a time of lists for Christmas presents and New Year resolutions, I thought it would be useful to provide a summary of key views on the global economy and investment outlook in simple point form, both from a 2012 and a medium term perspective. In other words, a list of lists. So here goes.

Key themes for 2012

• Fiscal austerity and deleveraging in Europe and the US.
• Monetary reflation with quantitative easing in Europe, the US, the UK and Japan and rate cuts in the emerging world and Australia.
• The emerging world to again account for most global growth.

• Global growth of 3%, 1% in advanced countries, 5% in emerging countries and 3% growth in Australia.
• Falling inflation and price deflation in some areas thanks to plenty of spare capacity.
• A volatile first few months in markets on continuing European woes, but then improving market conditions and returns as markets start to anticipate the next economic upswing helped by attractive valuations and easy monetary conditions.

Key risks for 2012
• Europe fails to reflate sufficiently or in time, resulting in a deep recession and possible break up of the euro.
• The US fails to extend payroll tax cuts and expanded unemployment benefits.
• China eases too late to prevent a property crash and hard landing in growth.
• Tension regarding Iran leads to a growth threatening surge in oil prices.
Four or (five) key indicators to watch
• The spread to German bond yields for Italy, Spain and France – a further narrowing would be a good sign.

• Chinese money supply growth – it has recently bounced off a decade low, but should improve if policy makers continue to ease.• The US ISM manufacturing conditions index as turn downs in mid 2010 and mid 2011 both inspired false “double dip” alarms.
• The $A is a good indicator of global growth – if it stays up things are okay. So far so good.
• …and December 21 when the Mayan calendar apparently ends, although as far as disaster movies go 2012 was rubbish compared to Towering Inferno!

Five reasons why the emerging world is in reasonably good shape

• Low public and private debt levels.
• Low per capita income levels = huge potential for further catchup in living standards and hence urbanization and industrialization.
• Inflation is falling, clearing the way for more monetary easing.
• The monetary transmission mechanism still works.
• Generally sensible economic management.

Seven reasons why if the world does go into recession it would be unlikely in Australia 

• Long way to go to zero for interest rates. Roughly 85% of mortgages are variable rate and hence households get a huge boost to spending power as rates fall.
• Low public debt by global standards means scope for fiscal stimulus if necessary.
• The $A will fall if need be, providing a buffer.
• Corporates have low gearing and are cashed up.

• Households have high savings rates which provide a buffer

• The mining investment boom provides resilience.
• Our trading partners are in reasonable shape.

Four reasons why the Australian dollar is likely to remain strong on a medium term view

• Commodity prices are likely to remain in a long term uptrend on the back of emerging world industrialization.
• Australian interest rates are likely to remain well above US, EU and Japanese interest rates.
• Quantitative easing will increase the supply of US dollars, euros, pounds and Yen relative to the supply of Australian dollars.
• Safe haven buying of Australian bonds as its one of only a few countries with a “stable” AAA credit rating. The others are Denmark, Norway, Sweden, Switzerland, UK, Canada, Liechtenstein, Singapore, HK and Germany (for now anyway).

Why medium term (5-10 year) economic growth in advanced countries and investment returns will be constrained and volatile

• Private sector deleveraging in advanced countries has a way to go, which will be a headwind for growth.
• Excessive public sector debt levels in Europe, the US and Japan and ongoing fiscal austerity.
• Extreme monetary policy settings, eg zero interest rates and quantitative easing, can inspire extreme market volatility when changes occur.
• The easy gains from 1980s and 1990s disinflation are over, and deflation (eg Japan over the last 20 years) or rising inflation (as in the 1970s) would be bad for shares.
• Social unrest is on the rise and politics is becoming more polarized (eg the tea party in the US and the “occupy movement”).
• The policy pendulum is swinging back to the left with less growth friendly policies (tax the rich, reregulate markets, trade barriers, etc) after the economic rationalism of Thatcher, Reagan and Hawke/Keating.
• Greater reliance for global growth on emerging countries which are usually more volatile.

What should investors consider in the current environment (partly inspired by my friend Dr Don Stammer)?

• The cycle lives on – history tells us that times of gloom will eventually give way to boom and vice versa. There is no such thing as a new era, new paradigm or new whatever. As the Bible tells us there is nothing new under the sun.
• The power of compound interest – regular investing of small amounts can compound to a big amount over 20 year plus timeframes.
• Buy low and sell high – starting point valuations matter. And the lower valuations thrown up by market weakness over recent years provides opportunities for far sighted investors.
• Focus on investments providing decent and sustainable cash flows – dividends, distributions, rents – as they are a good guide to future returns, a good buffer in volatile times and provide good income.
• Invest for the long term but for those with a short term horizon, such as those close to or in retirement, consider investment strategies targeting desired investment outcomes whether in the form of a targeted return or cash flow.
• Avoid the crowd – just as the crowd got it wrong piling into the “Japanese miracle” in 1989 (with Japanese shares falling for the next two decades), the “Asian miracle” of  the mid 1990s (which turned into the Asian crisis of 1997-98), the “tech boom” of the late 1990s (which turned into the tech wreck of 2000-03), the credit and US housing booms of mid last decade (which turned into the GFC) it might also find that the dash for cash of the last few years will ultimately prove to be wrong over the next five years or so.

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With US data becoming somewhat more reassuring of late and concerns about a possible hard landing in China also lessening, it has mainly been the worsening of the eurozone sovereign debt crisis that has been the biggest area of concern for markets. Consistent with this, among the worst performers this year have been the equity markets of the so-called PIIGS countries, with Greece languishing right at the bottom of the (MSCI indices) list with around a 60% loss.

From a technical viewpoint, the position we are at today has parallels with 2000 and 2007, when many global equity markets ‘topped’ and which signalled the start of global recessions. If the events of 2000 and 2007 were to play out again, then we could go significantly lower from here.  However, while this scenario is clearly a big risk, it is worth remembering that it is by no means certain to materialise.

For such an outturn to become more likely, we would first have to see a break below the summer 2010 market lows, especially in the UK & US. To date, the eurozone is the only region that is trading below these levels and is therefore already technically in confirmed bear market territory.

The key driver of European equity weakness has continued to be the region’s banks many of which reached new lows recently. Looking back to 2008/09, it is easy to recall that it was the governments that were forced to rescue the region’s banks. This time however, in a somewhat ironic reversal, it is the banks’ holdings of EU member country sovereign debt that is causing problems, along with the associated threat of a eurozone recession and the negative effects of forced deleveraging.

So the outlook for the European banks and the questions of whether they can break out of their current negative technical position looks increasingly dependent on whether a timely and effective resolution can be found to the eurozone debt crisis. The recent EU Summit provides some hope in this regard, but the situation still looks very far from resolved at present.

Amid all the gloom however, it is always possible to find some positives. From a technical perspective, periods of elevated pessimism do not last forever and tend be followed very often by some kind of bounce back, at least in the short term. Moments of extreme pessimism are also exactly what contrarian investors look out for on the basis that history shows these periods to be excellent times to invest. Finally, perhaps the single most supportive (albeit non-technical) factor for European equities at the present is that they appear cheap in terms of many key measures such as price-earnings, price-to-book ratios and dividend yields.

In the bond markets, eurozone government yields have dominated market attention in recent months. In November, Italian 10-year benchmark yields crossed above 7.0% – a level widely considered to be unsustainable. Likewise, yields in Spain also moved closer to the key 7.0% level. More recently, yields have fallen back partly owing to optimism stemming form the recent EU summit. However, even at current levels, the situation is far form comfortable.

Of course, the problem with rising yields is that they raise actual financing costs for governments, which raises further concerns about credit quality, which in turn pushes yields even higher, creating a vicious circle.

While US yields have generally continued to head even lower owing to safe haven inflows, in November, German bunds (another traditional safe haven play) took markets by surprise when their yields moved in the opposite direction (to US yields), following a ‘failed’ ‘primary auction. However, although this is a worrying sign, it seems unlikely that this marks the start of a significant (directional) de-coupling of US/German government yields.

Mounting concerns about credit quality in the eurozone sovereign debt markets have led to a generalised increase in investor risk aversion that has also affected other types of assets too. This includes high yield corporates where yields have picked up significantly in the past few months. Although price movements have naturally been less severe, the fallout of the eurozone sovereign debt crisis has also been evident in the investment grade sector. This is despite the fact that corporate fundamentals have remained solid, with no discernable pick-up in corporate default rates as of yet.

Looking ahead, the situation looks likely to remain challenging in both equity markets and bond markets, until we get more tangible progress on the dominant issue of the eurozone sovereign debt crisis. The EU summit was widely been seen as step in the right direction, but the markets will continue to look for more progress.

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The shadow cast by Europe means greater uncertainty than normal. However, despite reasonable profit growth, shares have fallen suggesting they have already discounted a lot of bad news. On top of this, everyone seems to be bearish and monetary conditions are easing further. If the ECB steps up its involvement, as we expect, and monetary easing continues elsewhere, shares will ultimately have a much better year ahead.

The main risk would be if Europe doesn’t get its act together and plunges into a deep recession. Other risks relate to a Chinese hard landing and fiscal austerity triggering weaker growth in the US.

2011 – a year of disasters
2011 was to be a year in which the global recovery became more self-sustaining, underpinning further gains in investment markets. Instead it has turned out to be a year of disasters, starting with the floods in Australia, the New Zealand earthquake, the Japanese earthquake, tsunami and nuclear disaster, civil war in parts of the Middle East and North Africa resulting in a surge in oil prices, the US debt ceiling debacle and ratings downgrade, and of course the deteriorating European debt crisis. The outcome has been rather disappointing, for investors with extremely volatile investment markets and poor returns from risk assets.

Against this backdrop the key macro economic themes have been as follows.

• First, global growth has been fragile and sub par with another bout of double dip worries around mid year in response to the earlier surge in oil prices, Japanese supply chain disruptions, monetary tightening in emerging countries and the blow to confidence from debt debacles in the US and Europe. While the US picked up pace through the second half, Europe looks to have fallen into recession and emerging countries have slowed.
• While inflation reared its head early in the year, particularly in emerging countries, it has faded into year end as growth has cooled and pressure has come off commodity prices.
• The global monetary cycle has swung from tightening to combat inflation earlier in the year, though mostly in emerging countries, to easing through the second half as growth slowed and inflation came back under control. Monetary policy has eased in most countries either via interest rate cuts or quantitative easing (ie printing money).
• Australia has also had a disappointing year, with disruption caused by the January floods resulting in a fall in GDP in the March quarter. Cautious household behaviour has led to constrained retail sales and weak housing related activity has offset booming mining investment. As a result inflationary pressures have receded and the RBA cut interest rates twice, in part reflecting the threat from Europe.
  This has all resulted in a rather disappointing ride for investors, particularly from around April.
• The following table shows returns for major asset classes. (Note the 2011 returns are for year to date to December 7).

• Despite reasonable profit growth, share markets have had a rough ride, rising early in the year before falling in the September quarter on worries about a global dip back into recession, partly on sovereign debt woes.
• Within global shares, US shares have been a clear outperformer, reflecting easier US monetary conditions, the lagged impact of the weak $US and better profit growth. European shares have been amongst the worst performers. Asian and emerging market stocks have been dragged down by worries about inflation early in the year followed by concerns about Europe.
• Australian shares performed poorly (albeit between US shares and European shares) thanks to relatively higher interest rates, worries about China and the lagged impact of the strong $A, which weighed on earnings growth.
• Listed property securities had a flat to slightly up year with their greater income yields offering some protection.
• The $A met our year end target of $US1.10 early in the year but has since languished around parity.
• However, it hasn’t been all doom and gloom. Unlisted non-residential property and sovereign bonds (except in troubled countries) provided solid returns. Gold made it to a new all time high of above $US1900 an ounce, and rose 22% over the year as investors sought a safe haven against falling values of major paper currencies.
• The poor returns from shares resulted in poor returns from traditional balanced superannuation funds.

Outlook for 2012 – bad then better?
Uncertainty hanging over Europe, and to a lesser degree the US and China, suggests a very uncertain outlook for the year ahead. However it’s worth noting, to borrow from Paul Keating, every pet shop galah is saying the same thing – Europe, Europe, Europe! So maybe it’s all factored in and – perhaps after an initial messy period, it won’t be so bad. There are several reasons for a bit of cautious optimism.

• First, Europe appears to be heading towards a resolution of sorts, which is likely to involve much greater ECB intervention, helping to limit Europe’s growth contraction next year to around -1%. The task is beyond the scope of various bailout funds (which aren’t big enough and are under ratings pressure) & the IMF does not have enough funds.
• The only organisation that can bring the debt contagion under control is the ECB. Our assessment is that it is likely to move into top gear in the next six months – and buy bonds in troubled countries more aggressively. A move towards fiscal union is likely to provide it with more confidence to act, the deepening European recession provides justification for aggressive monetary easing and bond buying in order to achieve price stability, and German opposition to a more aggressive ECB is likely to fade as its economy weakens too.
• Second, the US economy looks like it will continue to simply muddle along, perhaps even with another “double dip” worry around mid year, but growth being held up around the 1.5% level by more quantitative easing and solid profits supporting employment and business investment.
• Third, China looks like it could slow further in the short term, possibly taking growth to a low point of 7% year on year. However, with the property market and inflation cooling and the authorities not willing to tolerate a hard landing, policy easing is likely to become aggressive, resulting in overall 2012 growth of 8% in China. This is pretty much the story in the emerging world as a whole, ie short term weakness but plenty of scope to provide policy easing as inflation subsides which should support growth.

Pulling all this together suggests:

• Global growth somewhere around 2.5 to 3% next year, composed of 0.75% in advanced countries and around 5% in emerging countries, albeit looking worse earlier in the year before improving in the second half
• Falling inflation as commodity prices remain benign and spare capacity builds in advanced countries, leading to a bout of deflation in Europe
• More monetary easing with falling interest rates in the emerging world and commodity countries, but aggressive quantitative easing in the US, UK and to a lesser degree Europe (ie just enough)
• Intensifying currency wars as quantitative easing sees the $US, euro and sterling remain weak
• Constrained earnings growth reflecting the soft overall economic backdrop.

For Australia this means a difficult environment initially, before risks recede later in the year. Our base case is for 3% growth over the next year – ie better than the 2011 which was affected by the drought, but it probably will require more monetary easing with the cash rate expected to fall to 3.75% by end 2012 to help protect growth.

So what does this all mean for investors?

• In the short term it’s hard to feel confident on shares and related risk assets, as much uncertainty hangs around Europe and global growth could first get worse before it gets better. However, against this, shares are now very cheap particularly against bonds, monetary policy is easing further and everyone is bearish. So while shares may have a rough start to the year, there is good reason to expect them to be higher by year end. That a lot of bad news is factored into share markets is indicated by forward price to earnings multiples which are now 10.2 times for global shares compared to 12.4 times a year ago. In Australia, the forward PE is now 10.9 times compared to 13 times a year ago. In the emerging world and Europe, the forward PE is now just 8.5 to 9 times.
• Share markets to focus on are those with strong fundamentals & monetary easing (Asia, emerging markets & Australia) or those with weak currencies and monetary easing (eg the US where monetary easing is likely to be more aggressive over Europe). We expect the Australian ASX 200 to rise to around 4800 by end 2012.
• Commodity prices are likely to rebound after a possible initial soft patch once it becomes clear the global economy is not going into free fall and as quantitative easing (QE) ramps up in advanced countries. Gold is likely to rise through $US2000 an ounce on QE.
• The $A is likely to have a few rough patches, but is likely to remain strong overall, ending higher in response to more QE in the US and Europe, Australia being one of the few countries with a stable AAA rating, and as investors start to anticipate better commodity prices.
• Cash and term deposits are likely to become less attractive as cash rates continue to fall, pulling down term deposit rates with them.
• Very low starting point bond yields suggest low returns from sovereign bonds, unless of course global recession looms. Australian bonds are more attractive than global bonds given higher yields and less risk if things fall apart. Corporate debt is a better bet, but favour investment grade if you are worried about equities.
• Unlisted commercial property returns are likely to remain reasonable reflecting yields around 7%, requiring only modest capital growth to generate a decent return.
• Australian house prices are likely to fall another 5% or so in the first half as buyers hold back on economic uncertainty, before rate cuts reach a critical mass and greater confidence leads to a recovery in the second half.

What are the risks?
The main risk is that Europe does not act quickly enough to prevent a major financial meltdown and deep recession. If so, this would drag the global economy back into, or very close to recession. There is also a risk in China that the leadership transition and a desire to quash property speculation sees the authorities react too slowly to the slowing economy, allowing a move to a hard landing (ie 6% growth or less) to become entrenched.

If the world really does go back into recession, fortunately Australia has plenty of ammo to fight it off – rates have a long way to go to zero, the $A will fall if things fall apart globally, there is more room for fiscal stimulus if needed, the corporate sector is cashed up, the household sector has a strong savings buffer and mining projects impart a degree of resilience. This would all suggest 1-2% growth locally, but not recession.

Conclusion
Expect a rough ride, with potential weakness in the first part of the year. Conditions are likely to improve as monetary authorities in Europe and the US step up to the plate. So overall what many fear could be a disaster could turn out to be much better than expected.

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