Economic growth will continue to be hampered this year by the lingering effects of the global credit crisis. Those effects will include ongoing deleveraging, albeit partially offset by accommodating monetary policy in much of the world. Still, modest economic growth will be enough to allow corporate earnings to increase, which will provide the backdrop for equity markets to move higher, led by the U.S.
The most significant global risk remains financial breakdown in Europe, which, if it happens, would tip the entire developed world, and possibly the emerging world as well, into a new recession. In 2012, the big "swing factor" for the world economy will be the success of continuing efforts to fix Europe's debt and credit issues. Failure in this effort could be disastrous. But we don't need Europe to solve all of its problems in 2012 for the world to achieve an 'okay' year. Since there is already such a significant "crisis premium" baked into the markets, simply avoiding disaster could be enough.
In addition to Europe taking steps to resolve its debt crisis, positive moves for the global economy include the U.S. heading toward fiscal responsibility, a renaissance of U.S. manufacturing, a housing recovery, and an increase in confidence. Downside concerns include a systemic banking crisis in Europe, a true double-dip recession in the U.S., a hard landing in China, a break-out of class warfare in the U.S., and a Middle East flare-up resulting in $150-per-barrel oil. The most likely path will be a middle course that will avoid both the positive and negative extremes, but also leave a host of critical issues unresolved. But this middle course should be good enough to get investors off the sidelines, put their cash to work, and move into higher-risk assets. This bodes well for the stock market.
BlackRock believes that the world will likely experience a growing "divergence" in 2012 between the faster-growing emerging markets and the debt-ridden developed world in terms of their economies and asset prices. Under this divergence scenario, emerging economies (including China) will lead the way in growth, while the U.S. economy muddles on and Europe undergoes recession followed by slow recovery in 2013.
To be sure, we realize there is a real possibility of a far more challenging scenario sparked by an out-of-control European debt crisis. Such a scenario would result in a global recession, a credit crunch and steep losses across asset classes around the world.
U.S. Will Muddle Through
In the U.S., a strong corporate sector, an improving consumer sector, and a financially strapped government sector will combine to provide modest but positive growth for all of 2012. While some disappointments and positive surprises are likely, we expect an average growth rate of 2% to 2.5% for the year. As with the world generally, the U.S. economy can achieve an 'okay' year just by continuing to muddle through. We also expect unemployment to fall and jobs growth to proceed, but both at disappointing rates.
U.S. corporate earnings will grow moderately but fail to exceed estimates for the first time since the Great Recession. Indeed, since the start of the economic recovery in 2009, earnings have consistently exceeded expectations. However, the pace of earnings growth began to slow in 2011 and we believe that trend will continue in 2012. On balance, earnings reports will be acceptable, but not stellar. While estimates for 2012 earnings for the S&P 500 are currently around $108, we believe that $103 is more likely, with about 6% earnings growth.
At the same time, Treasury rates are likely to move somewhat higher in 2012 if the "crisis premium" that has kept risky assets cheap and Treasury rates low lessens. If the "left-tail" risk of the European debt situation lessens, risky assets should perform better with a reduction in credit spreads of all types.
But even while the U.S. economy slowly comes to life, equities will achieve a double-digit percentage gain in 2012 as multiples rise modestly for the first time since the recession. After contracting by about 15% in 2011, valuations will expand in 2012 as confidence improves on the back of acceptable, non-recessionary economic growth along with continued low inflation and interest rates. Should we see the sort of "muddle-through" environment we expect, that should be enough to bolster investor confidence, resulting in an inflow into equities.
Indeed, on the strength of reasonable earnings growth and cheap valuations, U.S. equities should outperform non-U.S. markets for the third year in a row. Emerging markets lately have significantly underperformed, due largely to monetary tightening based on inflation concerns, leading to economic slowdown. At some point, perhaps this year, emerging market equities will resume outperformance. Meanwhile, Europe's debt crisis and Japan's persistent structural problems will hold those regions back relative to the U.S.
Opportunities for Investors
• Overweight equities: We have said it several times, but it bears repeating: as long as the world manages to slog along in a slow-growth environment, stocks should outperform in 2012, given the combination of decent earnings, low interest rates and attractive valuations. As such, we would recommend moving to overweight positions in equities relative to cash and bonds.
• Stick with free cash flow and dividend growth: Our main investment theme for 2012 is a focus on free cash flow. While many are talking about the attractiveness of dividend payers, we would add an important nuance: it is not dividend payments themselves that are attractive, but the quality of those dividends and the ability to grow them that investors should seek out.
• Focus on U.S. stocks: As was the case in 2011, we expect 2012 to be a year in which U.S. stocks outperform international markets. Economic growth should continue to be better in the United States compared to other developed markets. While our long-term view of emerging markets remains positive, we are not convinced that the near-term underperformance trend of those markets is at an end.
• Rotate to attractive areas of the market: From a sector perspective, we favor health care and energy and have a less positive view toward financials and utilities. From a style perspective, we have a slight preference for growth over value and are neutral regarding capitalization trends.
• Expect further divergence of returns: For some time, markets have been trading in a "risk on/risk off" fashion and we expect that these trends will diminish as investor sentiment improves. This suggests that we will see heightened dispersion between the winners and the losers in 2012, meaning that security selection will become more critical.
Robert C. Doll is chief equity strategist for Fundamental Equities at BlackRock Inc. He is also lead portfolio manager of BlackRock's Large Cap Series Funds.
10 Predictions For 2012
• The European debt crisis begins to ease even as Europe experiences a recession.
• The U.S. economy continues to muddle through yet again.
• Despite slowing growth, China and India contribute more than half of the world's economic growth.
• U.S. earnings grow moderately but fail to exceed estimates for the first time since the Great Recession.
• Treasury rates rise and quality spreads fall.
• U.S. equities experience a double-digit percentage return as multiples rise modestly for the first time since the Great Recession.
• U.S. stocks outperform non-US markets for the third year in a row.
• Dividends and buybacks hit a record high.
• Healthcare and energy outperform utilities and financials.
• Republicans capture the Senate, retain the House and defeat President Obama.
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