In many respects the investment outlook for 2012 looks distressingly similar to the final months of 2011. That is to say the challenges and outcomes will remain dominated by concerns of the past year, namely the Eurozone crisis and doubts about the sustainability of the global recovery. The implication is that financial markets will remain largely range-bound and characterised by elevated levels of volatility and unusually high correlation amongst risky assets.

2011 was not a great year for investors. Global equities lost 10%, giving back all of 2010 gains, and to be only partially offset by a 5% return on global fixed income. Commodities were down 8% while the credit component of spread products suffered significant losses. The world economy grew at a sub-par 3% in 2011, less than the 4% of 2010.

2012 is starting out to be rather similar. In terms of economic outlook, the consensus forecasts suggest another 3% global growth. Despite a modest re-acceleration in the US, the global economy will remain hamstrung by slowing growth in China and India, mild recession in parts of Europe and an anaemic recovery in Japan.

The bright spot now seems to be in the US where we are seeing cyclical improvements in manufacturing, consumer confidence and the labour market. It looks likely that US growth will top the 2% consensus forecast for 2012. Still, the structural forces of deleveraging of the household, banks and state governments will continue to hold back growth potential. Moreover, partisan politics is likely to prevail through to the November Presidential election, preventing meaningful progress in fiscal and regulatory reforms until 2013. 

The outlook for the Eurozone is rather dim with consensus forecast of a mild recession in the first half of 2012 and recovering later to close the year flat. Worsening the outlook is further fiscal tightening and more restrictive credit conditions. The risk is clearly on the downside. Also, the private sector which is one of the few bright spots in Europe could be severely hampered if the flow of credit is disrupted by continued stresses in the banking sector. 

Japan is still plagued by anaemic growth notwithstanding government spending to repair the damage wrought by last year’s earthquake and tsunami. The strong yen continues to hamper Japan’s large multi-national corporations which are heavily reliant on exports. Adding to this, the ruling Democratic Party of Japan has been largely ineffective in tackling economic issues as it is busy grappling with an internal revolt over its decision to raise the consumption tax from 5% to 10% by 2015 risking the chance of a snap election in 2012. 

And in most emerging economies, growth is likely to slow in the first part of 2012 due to the lagged effects of policy tightening as well as the adverse impact from the Euro crisis. This has the effect of negating the positive momentum in the US. However, with inflation peaking, we believe some of these countries such as China and Brazil will reverse their tight policies in the first half of 2012 to refocus on growth.

Besides economic doubts, the more pressing issue continues to be the Eurozone sovereign debt crisis. After what seems like a never-ending stream of summits in 2011, policymakers in the Eurozone have yet to find a lasting solution. Investors continue to be worried about the government funding needs this year – Eurozone governments will need to refinance more than €1 trillion of maturing short-term and long-term debt in 2012. The focus is now squarely on Italy which many consider as too big to fail and hence a real test for the crisis. With yields on Italian 10-year bonds above 7% and Europe's bailout fund having to offer higher interest rates than in the past to place €3 billion of debt, markets will continue to be vexed.

All said we believe the problems of 2011 – doubts about global cyclical recovery and the euro-zone structural debt crisis – will continue to pre-occupy investors’ minds and remain a source of sharply shifting risk premiums in the initial months of 2012.

However, it is also important to note that in several respects 2012 is different from 2011. For one, market prices have already factored in most of the current woes. The US 10-year Treasury yields have dropped more than 100 points in 2011 and are now trading just below 2%. Gold is some 13% higher while equities are anywhere between 10-30% lower, except for US equities which closed 2011 just about flat. During the year, global corporate earnings continued to grow by 5% which means price-to-earnings multiples have fallen even more and are now at levels similar to the first quarter of 2009 before the market recovery.

True, these levels do not matter much if global risk premiums continue to rise because of the unabating macro and event risks. But it does suggest a couple of things. First, the winning strategies of 2011 – US Treasuries, high-grade bonds, precious metals, JPY, CHF and the US dollar – look less compelling at current levels. Second, should these macro risk factors start to recede, the scope for a massive rebound is good especially coupled with a market positioning that is still highly defensive. 

The second difference is inflation. For most of 2011, emerging markets (EM) especially in Asia and Latin America were battling rising commodity and asset prices – a result of the massive domestic credit expansion as well as capital inflows from developed economies. Policymakers in these emerging markets tightened policies and allowed their currencies to strengthen fuelling hard-landing worries and resulting in massive underperformance in their equity markets. In the final months of 2011 however, inflation seemed to have peaked and asset prices started to correct. Some, like Brazil, Thailand and Indonesia, have started to cut key interest rates while most have also allowed their currencies to depreciate against the USD. In China, policymakers have cut banks’ reserve requirement ratio and started to focus on growth initiatives. The expectation of a stabilisation in EM growth together with a more durable US recovery could potentially offset the negative impact of a Eurozone recession provided it is shallow and temporary.  

For these reasons, 2012 should turn out better for risk markets albeit with continued volatility. We expect a reversal of 2011’s performance which started out strong and then crashed. 2012 will instead start with a surplus of pessimism and defensive positions, with upside surprise in the second half from receding risk of a Eurozone break-up and a more durable global recovery.

The implication for our asset allocation is to continue with an underweight stance in government bonds (both nominal and inflation-linked), a slight underweight in equities and overweight in corporate bonds and precious metals.

When we will start to become more positive on risk assets will depend largely on the evolution of macro risk factors which include stress points in the Euro-zone, China real-estate and US fiscal policy as well as the strength and sustainability of the global cyclical recovery.

Of the various risks, a break-up of the Eurozone ranks as the highest risk because of its size, leverage and inter-connectedness. It could potentially dwarf the impact of the Lehman collapse. With the benefit of hindsight, our current view is neither a dissolution nor an instant resolution. Instead, as German Chancellor Angela Merkel suggested, the move towards a resolution is like running a marathon. It will be incremental with many setbacks. Unfortunately this timeframe doesn’t sit very well with investors who are getting impatient causing shifting risk premiums in the markets.

The correction in Chinese property market is a concern given the export and manufacturing slowdown at the same time. However, the current slowdown has much to do with policy tightening and can arguably be reversed. As for the property market, the current leadership left no doubt that they are bent on pricking the bubble before it could impose more deleterious effects on the economy like in the US in 2007-2009. We believe they will continue to micro-manage the sector with administrative tools while allowing for looser monetary and fiscal policies to tackle the economic slowdown. This is definitely a risk factor we do not want to underestimate or overplay but must be monitored closely. On the US fiscal issue we see the standoff between the two political parties as continuing to the November Presidential election but with neither side risking a collapse.

All said it is too early to abandon the defensive position. Stay tactical and there should be opportunities to redeploy some time during this year.