There is no way around it: we got very lucky in 2012. Economies and markets this year narrowly sidestepped a number of potential stumbling blocks, including a European banking crisis, a “Grexit” from the Euro, a Chinese hard landing and an indecisive US election. Economic growth remained weak, but the lack of a crisis coupled with unprecedented monetary stimulus was enough to produce a good year for most asset classes.
Despite some of the good news, many of the major risks that characterized the world a year ago remain. Premature fiscal tightening is now a clear and present danger to the US, and no progress has been made when it comes to the longer term fiscal outlook. In Europe, while the ECB has bought politicians time, there has been only modest progress on banking reform and structural reforms. Finally, the Middle East remains as volatile as ever.
So what is our outlook heading into 2013? In our latest Market Perspectives report I outlined 3 potential scenarios with accompanying probabilities and possible investment strategies:
- Slow but stable (65% probability). Going into 2013, we see some evidence of stabilization in global indicators, particularly in the US, China and other emerging markets, suggesting that the absence of an exogenous shock should continue to expand throughout the year. In this scenario, we would expect slow growth coupled with low inflation and reasonable valuations, which should be enough to produce respectable returns for global equities. Possible investment strategy: overweight high dividend global stocks, mega caps, emerging market equities and municipal bonds.
- Stumbling over the cliff (20% probability). While the environment in Europe and the outlook for emerging markets appear more stable than a year ago, we still see a small chance of another global slowdown. The risk is that the global economy - still adapting to the aftermath of the credit bubble and a secular change in China’s growth rate - is not strong enough to withstand a substantial shock. Possible investment strategy: overweight Treasuries, gold and mega caps.
- Life in the fast lane (15% probability). Although unlikely, there is some chance that we will see a more substantial recovery in 2013. Potential catalysts include structural reform in emerging markets, banking and fiscal reform in Europe (although we view this as highly unlikely ahead of the German federal elections in the fall), or a grand budget bargain in the US that leads to a surge in corporate spending. The latter is arguably the most realistic. Possible investment strategy: overweight risky assets (e.g. global technology stocks, high yield bonds and cyclical commodities such as industrial metals).
For better or worse, we believe 2013 is likely to continue to be a year when the market’s fate will rest largely in the hands of politicians and policy makers. Avoiding the fiscal cliff, real progress on the long-term US fiscal outlook and structural reforms in Europe could unleash corporate spending, risk taking and animal spirits (i.e. consumer confidence). Conversely, failure to address these lingering policy issues - particularly the US fiscal position - will lead to at least a moderate recession, and potentially worse.
For now, we remain cautiously optimistic, but are cognizant that the real hard work needed to restructure the global economy remains, and the commitment of politicians is still an open question.