For stock market investors, 2011 was a volatile, frustrating year. While we’ve been mired in a turbulent trading range for over two years now, as shown in the chart below, the upside is that, in time, this trading range builds the base needed to launch a renewed bull market.

Still, risks remain as the stock market continues this period of consolidation. Therefore, let’s take a closer look at a few of the biggest fear factors for 2012: “the Killer B’s” that may impact markets this year. Also, we’ll point out some attractive investment opportunities we’re identifying in this climate.

Brussels Battles the PIIGS

Policymakers in Brussels, the seat of power for the European Union (EU), have been working overtime for more than two years to solve the ongoing EU debt crisis.

However, progress has been painfully slow, and the uncertainty surrounding this key issue contributed heavily to market volatility last year and is likely to continue into 2012. Here’s why:

1. The PIIGS countries of Europe have debt levels that are simply unsustainable and must deleverage. However, this process is painful economically.
2. Europe’s banks are struggling; holding too much questionable sovereign debt on their books with too little capital to back it.

Structural debt burdens in the PIIGS countries have made their economies uncompetitive with core EU nations such as Germany. Unlike the US, these peripheral EU countries don’t have their own currency and independent monetary policy to inflate their way out of trouble.

Instead, the EU imposed austerity measures in an attempt to shore up the PIIGS’ balance sheets. However, these measures have pushed the economies of Greece, Portugal, etc. into contraction due to reduced spending and income, but debt levels remain the same.

In other words, if the root cause of the problem is an unsustainably high debt-to-GDP ratio, shrinking the GDP part of the equation has only made matters worse.

The spillover effect of austerity is that the EU economy is on track toward another recession, if it’s not already in one now. As a result, Europe’s banks are facing a crisis of confidence too.

Tightening credit conditions hit European banks especially hard. EU banks are more highly leveraged than most global financial institutions, including US banks. Plus, they are more directly exposed to the fallout from the crisis with their balance sheets chock full of questionable PIIGS debt.

For instance, lenders were compelled last year to take a 50 percent hair cut on Greek government debt.¹

Many of Europe’s undercapitalized and overleveraged banks have no choice but to cut back lending and/or sell assets. According to estimates, Europe’s banks may collectively need to sell somewhere in the neighborhood of $2.6 billion to $3.9 billion worth of assets to meet stricter capital requirements this year.²

As a result, investors are shunning Europe’s banks, which are losing deposits and finding it difficult to access short-term funding from institutions.

Against this backdrop, EU ministers in Brussels have been busy crafting temporary solutions to fund the PIIGS and backstop the banks. Following in the footsteps of the US Federal Reserve, the ECB, in just the past six months, has already expanded its balance sheet by more than $650 billion directed at lending and outright debt purchases in an effort to hold down EU interest rates.³

So far, the results have been mixed. Government borrowing rates in Italy and Spain edged higher during 2012, moving into the danger zone where it becomes too costly to roll over short-term debt. The trouble is these two nations are simply too big to bail out.

The good news is that progress is being made, although Brussels has so far come up with mostly band-aid solutions. The never ending supply of quick-fixes has undermined investor confidence, contributing to intense volatility.

It’s easy to imagine a number of nightmare scenarios — from massive bank failures in Europe to a disorderly debt default or even a disintegration of the EU itself.

We’re less concerned about these extreme outcomes, however, than we are about the bigger picture. A continuation of this muddle-through approach in Brussels with ongoing deleveraging across Europe could mean a prolonged recession.

Beijing: the Wildcard

In addition to the more visible debt drama taking place in Europe, investor anxiety is also on the rise concerning an economic slowdown in China.

After several years of easy money and massive stimulus from Beijing to counteract the 2008 global credit crunch and recession, the government was busy tightening monetary policy last year to combat rising inflation.

Now there is a growing chorus of worries that Beijing may have gone too far ... as credit conditions tighten significantly. Many small and mid-size Chinese businesses have found it difficult to obtain lending at anything less than loan-shark-like rates of interest (6 percent per month works out to a compound annual interest rate of 89.8 percent!)⁴

Fears are growing over the possibility of a hard landing for China’s economy in 2012... and perhaps a crash landing in its real estate markets.  

China’s economy is clearly slowing as evidenced by official data on exports and industrial production. The good news here is that inflation appears to have peaked and is coming down. The consumer price index peaked at 6.7 percent in October and is now down to just 4.2 percent.⁵

This gives Beijing maneuvering room to ease monetary policy and lift credit restrictions, which is already taking place after Beijing recently cut banks’ reserve requirements.

It remains to be seen to what degree China’s economy slows in 2012. Europe is a key export customer and faces the prospect of recession, as mentioned above, which may further undermine Chinese exports. Still, China is a command economy, and Beijing has plenty of resources at hand to boost its economy.

Also, it’s not exactly a doomsday scenario for an economy to slow from a blistering GDP growth rate of 10 percent-plus in recent years, to merely exceptional growth of 8 to 9 percent in the year ahead.⁶

Beltway Bickering

Ironically, heightened concerns about what’s happening in Brussels and Beijing have global investors rushing headlong into US dollar assets. Foreign bank deposits at the Federal Reserve more than doubled to $715 billion during the first nine months of 2011. Net purchases of US stocks and bonds by international investors totaled $68.6 billion in September alone ... a month after the US credit rating was cut.⁷

Relatively speaking it’s clear that US asset markets may be among the best bets for investors in an increasingly uncertain world during 2012.

To be sure, the US economy faces its fair share of challenges. For one thing, politicians on this side of the Atlantic don’t appear to be any more capable than their EU counterparts in solving our fiscal problems.

The bad news is that this is an election year, which means there’s not much hope the current band of Beltway representatives will change their dysfunctional behavior. In fact, more partisan bickering is likely as campaign season drags on. However, the good news is that this is an election year and we have the opportunity to throw the bums out come November and choose more wisely.

In spite of the election-year anxiety however, it’s clear the US economy offers several positives to global investors ...

Short-term, inter-bank lending rates continued to rise, but remain far below the levels associated with the 2008 financial crisis. Rather than cutting back, as European banks are doing, US banks continue to ramp up lending with commercial and industrial loans expanding 9.4 percent from a year ago.⁸

The creditworthiness of U.S. companies remains strong and high-quality companies are still able to access the market at low absolute rates of borrowing. Plus, investment-grade and high-yield corporate bond spreads are well above their historical averages, providing attractive opportunities in select companies.

Consumer spending, which accounts for 70 percent of the US economy, has been resilient despite negative sentiment. Consumption growth should continue at a healthy pace as long as employment gains continue.

Our 2012 Outlook

While making hard and fast “predictions” for the New Year is always a mugs game, made even more difficult by the uncertainties we face now, here’s our cautiously optimistic outlook.

Significant headline risks remain. This continues to cast a climate of uncertainty over financial markets and the economy and could extend the volatility in markets.

The global economy slowed in 2011 while the US, by contrast, showed definite improvement near year-end in a range of economic indicators.

Relative strength domestically may be a key theme in the year ahead. Solid corporate fundamentals and discounted valuations provide upside potential for high-quality US stocks and high-yield bonds in 2012.

A climate of slow but positive economic growth should translate into continued profit growth for US businesses. American households have been paying down debt, while maintaining consumption at a healthy pace as the job market improves and housing stabilizes. Taken together, this provides hope for a better year for US stocks — particularly high-quality, globally competitive companies.

Now let’s take a closer look at how this outlook is influencing our portfolio management decisions.

First, we anticipate global growth at a somewhat below average pace this year, with emerging markets continuing to lead the way. Developed markets, held back by the headwinds of deleveraging, will show sub-par growth, especially the EU, which may already be in recession.

Second, slow growth and fragile investor sentiment warrant a degree of caution, which is why we have raised cash levels in our managed equity portfolios to a higher level than is typical. We anticipate putting this cash back to work opportunistically as market conditions warrant.

Third, prices of many high-quality US stocks and high-yield corporate bonds adjusted downward in 2011, perhaps to the point where they already reflect the challenges that lie ahead.

In other words, current valuations in many individual stocks and sectors are compelling, even for a slow growth environment.

Any positive surprises could provide a powerful upside catalyst in 2012. Some of the sectors where we see upside potential this year include energy, financial and technology stocks. But, as always, selectivity is very important in this volatile market.

Our fixed income asset allocation continues to favor a mix of high-yield and high-quality corporate credit, as well as international bond exposure, where yields are generally higher. Today’s low yield environment is as challenging for fixed income investors as volatile markets are for equity investors.

At Banyan, we favor an average duration of three years or less in our custom fixed income portfolios, and we’re venturing beyond traditional long-term bonds. For example, select mortgage-backed securities appear attractively valued at present.

If there’s one time-honored lesson we’ve learned from many years of professional experience, it is the virtue of contrarian thinking. This is especially important when considering consensus views on the economy, stock market forecasts, or for individual company prospects. The consensus is not always wrong, but often misses opportunity by myopically focusing on the recent past.

In January 2011, the consensus called for the robust stock market gains that started in March 2009 to continue. That obviously didn’t happen as the S&P 500 Index ended up a disappointing 2 percent last year with plenty of volatile swings along the way.⁹

This year, the consensus is more conservative on the outlook for US stocks than at any time in the past seven years, forecasting a gain of just 6.4 percent for the S&P 500 Index.¹⁰

While anything can happen, our contrarian view at Banyan favors taking the “over” on this consensus forecast in 2012.

Happy Holidays,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Bloomberg news, 12/21/11
² Fidelity Investments Viewpoints, 12/21/11
³ Ibid.
⁴ Ibid.
⁵ Bloomberg market data, 1/4/12
⁶ Ibid.
⁷ Bloomberg news, 11/21/11
⁸ Fidelity Investments Viewpoints, 12/23/11
⁹ Bloomberg news, 1/3/12
¹⁰ Ibid.