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According to the Chinese zodiac, 2012 is the Year of the Dragon – an auspicious symbol of good fortune and power. After enduring a roller coaster ride this year, investors will need all the good luck they can get in 2012.

Many of the themes of 2011 will carry over to 2012. The sovereign-debt crisis in Europe, the U.S. budget deficit, and the continuing debate over the sustainability of China’s economic growth will continue to weigh on investors next year.

Investors are pessimistic and there’s not much in the way of excitement when it comes to the stock market. Although such anxiety is understandable and justified, it sets the stage for contrarian calls. In other words, if the majority of investors expect a negative outcome, the markets may surprise by posting strong gains.

The global economy will not enter a recession in 2012 and will post decent economic growth of about 3.5 percent. This means that the valuations in emerging markets, particularly in Asia, are relatively supportive; although current valuations already discount the chance of a recession, they haven’t priced in a total collapse of the global financial system. This means that emerging-market stocks should be able to deliver positive returns next year.

Asian markets have priced in a recession. Although this is not my base-case scenario, it’s a possible outcome and some indicators – most notably the OECD leading indicator – have already begun to signal a looming recession. On the other hand, other indicators such as China’s purchasing managers index or U.S. capital expenditures suggest that the global economy will experience a soft landing at the very worst.

That’s an important distinction because the U.S. economy must avert recession if the global economy is to post respectable growth in 2012. With Europe struggling to get its arms around the sovereign-debt crisis, U.S. growth will be critical to the health of the global economy.

Financial chauvinism among some European leaders has damaged the credibility of the eurozone’s efforts to deal with the crisis. Latvia’s “success story” will not work for Italy or Spain; the sooner the leaders of Europe’s core economies come to this conclusion, the better off their economies will be. Transforming the EU into Germany or Latvia will never work. The EU must take a more balanced approach to resolving the crisis if the euro experiment is to move forward.

On this side of the pond, some leading indicators for jobs, such as unemployment insurance, have improved. U.S. jobless claims recently dropped below 400,000. As you can see in the chart below, this is a marked improvement from the 2009 high of 659,000 jobless claims.

If U.S. jobless claims continue to decrease, there’s a strong probability that the U.S. economy can avoid recession, even if some of the stimulus-related programs (such as the payroll tax cur) are terminated at the end of the year.

Description: http://kr.nlh1.com/images/BISHOP/GIS.yiannis.claims.GIF
(Click to enlarge)

Source: Bloomberg

Given the short-term and long-term challenges facing developed economies, emerging markets look like relative bastions of stability and growth. This is particularly the case for the larger emerging-market economies.

The main developing economies, especially those in Asia, currently boast the fundamentals for solid growth, combined with low levels of sovereign debt. The strength of these economies will eventually be reflected in the performance of their stock markets, especially when investors allocate more funds toward stocks.

Emerging markets underperformed developed markets this year for two reasons: Europe’s sovereign-debt crisis and concerns over high levels of inflation. In times of distress, investors reduce their allocation to what they perceive as risky assets, and emerging markets suffered as the EU debt crisis battered sentiment and roiled markets – an understandable repercussion of the turmoil on the Continent.

On the other hand, concerns that rising inflation in Asia would derail the global economy proved to be overblown. The most important emerging economies, with the exception of India, have been able to address this issue decisively. This is the reason that emerging markets have performed so strongly since October.

Inflation in China dominated the headlines this year. China has a certain appeal to the bear inside every investor. Sometimes this bearish attitude may be politically motivated, but nevertheless, there’s a tendency to exaggerate the news that comes out of China. Even good economic news can be spun in a negative light. Given that inflation usually accompanies strong economic growth, fears of runaway prices in China this year were blown out of proportion.

As I noted many times throughout 2011, inflation in China was primarily driven by rising food prices, which would eventually subside. The November economic data from China reflects a steady decline for food and non-food prices in the country.

But lower inflation doesn’t mean that China will embark on an expansionary economic policy. At present, the country’s leadership doesn’t believe that such action is required. Nevertheless, should the Europe sovereign-debt crisis spiral out of control, expect a strong response from the Chinese government. China will do everything it can to protect its domestic economy now that it has begun the year-long process of transferring power to a new generation of political leaders.

Nevertheless, pundits will likely seize on an overheated property market as the next thing to bring down the Chinese economic juggernaut. But a crash for China’s property markets is unlikely in 2012. Although property prices could fall by an additional 10 percent to 20 percent, the broad Chinese economy shouldn’t suffer much, as long as this correction occurs in an orderly fashion.

Expect China’s gross domestic product (GDP) growth to come in above 9 percent in 2011. China’s GDP should grow by about 8 percent in 2012, although the global economic environment remains fragile.

However, China’s latest Five-Year Plan for 2011 to 2015 calls for annual long-term GDP growth of 7 percent and investors should prepare for the possibility of slower growth from China. The country’s leadership is comfortable with this outcome, so long as it’s achieved with minor disruption to social stability.

Asian Markets

Asian markets, as represented by the MSCI Asia ex Japan Index, trade at very appealing valuations. Asia trades at around 1.5 times book value, which is close to what the region has traded at during recessions and certainly below the long-term average of 1.8 times book value. As you can see in the chart below, valuations for Asia hit their lowest levels of 0.92 times book value in 1983 and 1999.

Description: http://kr.nlh1.com/images/BISHOP/GIS.Yiannis.PB.GIF
(Click to enlarge)

Source: Bloomberg

Even these attractive valuations in Asia could not offset macro-level worries in the market. As a result, many investors are currently moving away from value and trying to chase momentum plays.

Although this may prove to be a rewarding short-term move, the fact remains that long-term investors in Asia have done best when they have bought stocks at low valuations and held those positions for some time. This doesn’t mean that investors shouldn’t periodically take profits off the table. But buying stocks at reasonable valuations provides you with the luxury of waiting for a market turnaround while secure in the knowledge that you didn’t overpay for your holdings.

This attitude will prove to be even more important in 2012. Next year global macro-level uncertainty will remain elevated and investors are already beginning the year with low expectations for Asia.

The guiding theme for 2012 is that large-caps will outperform. With slower economic growth all but assured in 2012, the companies that can endure the lull while protecting earnings will come out on top. Large-cap companies are in the best position to weather the economic hardship with their balance sheets intact.

Finally, an analysis of the chart above suggests that the markets may struggle in the short term. There is strong resistance at the 500 level and good support at around 400. The market may very well trade between these two values until the global macro picture becomes more clear.

We’ve long contended that the markets will force the Europeans to deal with the sovereign crisis in a more decisive manner. In the meantime, probably during the next three months, the European Central Bank (ECB) will need to embark on a more direct program of quantitative easing, if only to buy time for the Continent’s politicians.

If quantitative easing begins, expect Asian stocks to gain fast and strong by as much as 30 percent. On the other hand, if the ECB fails to act, the markets could sour more and easily bring the MSCI Asia ex Japan Index below 400 points.

If the EU fails to resolve the crisis, the consequences would be devastating for the markets and the global financial system. Though unlikely, it’s a true doomsday scenario, and consequently it’s all but impossible to forecast market levels if this scenario unfolds.

Source: Emerging Markets: What To Expect In The Year Of The Dragon