European debt crisis begins to ease even as Europe experiences a recession
06.01.12 09:33

New York, January 5, 2012 –- 2012 will offer investors a slow growth world in which the United States will face headwinds, yet still achieve positive economic growth, and Europe will likely slip into recession while avoiding more dire financial contagion, according to Robert C. Doll, Chief Equity Strategist for Fundamental Equities at BlackRock, Inc. (NYSE: BLK).

 
Predictions for 2012
 
Here are Doll’s predictions for 2012 with his full commentary on the key trends.
 
1.    The European debt crisis begins to ease even as Europe experiences a recession.
      
The European debt crisis loomed large and drove high levels of volatility in 2011, causing most risk assets to experience significant downturns.  Unfortunately, the debt crisis will continue to dominate risk discussions for 2012 as well.  Thankfully, the authorities – political and monetary – 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.  Formulating incremental fiscal union, creating the enforcement mechanisms for austerity measures, and attempting to generate economic growth are each difficult, and seem impossible when combined.  Nevertheless, we believe that all parties recognize 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.
 

2.    The US economy continues to muddle through yet again.

The US economy ended 2011 stronger than it started, although growth continues to be lackluster.  Our view is that the deleveraging process will continue to limit growth to a sub-par rate, but that 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.  Modest employment gains are key to reversing the steady decline in corporate and consumer confidence.  Low interest rates, a bottoming process in housing and low inflation could aid the economy in its “muddle-through.” We also believe that European recession and fiscal policy drags will become important headwinds.
 

3.    Despite slowing growth, China and India contribute more than half of the world’s economic growth.

Emerging market economic growth continues to be a critical part of global growth in both the short and long term.  China and India are especially important given both their size and growth rates.  And while growth in both countries is likely to be slower in 2012 than it was in 2011, together these two countries will account for more than half of 2012 global growth.  We expect China will account for more than 40% of global growth, with India and the U.S. accounting for about 15% each. Until recently, increasing inflation in the emerging markets has caused policymakers to raise interest rates and/or reserve requirements in an attempt to slow inflation, with the effort of dampening growth. We expect that process will begin to reverse itself sometime in 2012.
 

4.    US earnings grow moderately but fail to exceed estimates for the first time since the Great Recession.

One of the standouts of 2011 was the performance of corporate earnings.  S&P 500 per share profits consistently beat expectations, increasing approximately 14% despite a relatively weak macroeconomic backdrop. This trend of surpassing expectations has been in place since the start of the economic recovery in 2009, but we believe the trend is nearing an end.  Our view is that the pace of earnings growth will slow in 2012 and will fail to exceed expectations (currently $108) for the first time this business cycle.  Comparisons are getting tougher, the dollar has strengthened somewhat, profit margins are unlikely to climb further, and non-US growth is slowing.  All of this points to acceptable, but not stellar, earnings reports.
 

5.    Treasury rates rise and quality spreads fall.

Arguing for interest rate increases has been fruitless for some time as investors have been in a persistent “risk off” trading mode.  Having said that, at some point we think 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. We think the latter environment is more likely.  If the “crisis premium” that has kept risk assets cheap and Treasury rates low lessens in 2012, Treasury rates are likely to move somewhat higher.  That is indeed our premise with the European sovereign debt problem being the chief candidate for some improvement.  Should that risk lessen, risk assets should perform better, which would include a reduction in credit spreads of all types.  On a related note, we are not yet convinced that a QE3 program of size from the Fed is a given unless European credit markets freeze further and/or the US economy noticeably stumbles.


6.    US equities experience a double-digit percentage return as multiples rise modestly for the first time since the Great Recession.

We are forecasting that earnings rise around 6% in 2012. Should that happen, and should stocks continue yielding somewhere around 2%, it would take only modest valuation improvements to reach double-digit return territory in 2012.  We believe valuations are compressed for a host of “risk” concerns, most notably the risks associated with potential European financial contagion.  After contracting by about 15% in 2011, we think valuations will expand modestly in 2012 as confidence improves on the back of acceptable, non-recessionary economic growth, continued low inflation and interest rates, and modest net new job growth.  Strong financial health in the corporate sector should provide some support as well. Importantly, as with many of our predictions, we do not believe that it will take a return to boom conditions for this one to come true—simply avoiding the “nemesis” scenario should be enough to allow for decent gains for US stocks.
 

7.    US stocks outperform non-US markets for the third year in a row.

The US stock market has been a standout performer over the last two years compared with other equity markets. In 2011, US stocks were roughly flat and significantly outperformed non-US markets, many of which were down double-digit percentages.  With reasonable earnings growth and attractive valuations, we think the United States can outperform again in 2012.  That will require modest economic and earnings growth compared with recession in Europe and malaise in Japan.  Emerging market underperformance has been significant largely due to monetary tightening stemming from inflation concerns which has resulted in economic slowdown.  At some point, perhaps sometime during 2012, emerging market equities will resume outperformance, but we think it is too soon to make that call now.
 

8.    Dividends and buybacks hit a record high.

Cash spent by US corporations to raise dividends and buy back stock increased approximately 35% in 2011.  Despite that, cash as a percentage of profits used for these purposes is still below long-term averages.  As a result, it is possible that the amount of cash used for these purposes grows by another 20% or more in 2012, which would surpass the record dividend increase and share buybacks set in 2007.  On a related note, corporations 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.
 

9.    Healthcare and energy outperform utilities and financials.

Our sector preferences include one defensive and one cyclical sector.  Healthcare should benefit from continued good and 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.  Our underweight position stems from continued concerns regarding revenue growth potential, regulatory risks and deteriorating and residual credit concerns.  Finally, we believe utilities are overvalued, especially given weak earnings prospects.
 

10.  Republicans capture the Senate, retain the House and defeat President Obama.

Predicting elections is always treacherous and assessing the impacts is even more precarious.  At this stage, our view is there is a strong chance the Republicans retain the House of Representatives while losing a few seats, a reasonable chance they capture the Senate and, while a very different call, win the Presidency.  The last part of this prediction is especially difficult given the President’s advantage of incumbency and campaign war chest and the uncertainty as to the eventual Republican nominee.  Critical to the President’s re-election chances are his approval ratings and the unemployment rate, neither of which are currently in his favor.  From a markets perspective, we would point out that, historically, equity returns have been strongest under Republican control of Congress regardless of the President’s party.
 
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