The global economy in 2012 will likely remain in its ‘great idle’ with slow, positive growth and an economic crisis avoided, according to Russ Koesterich, Global Chief Investment Strategist for BlackRock’s iShares business.
However, the odds of another global recession, the result of policy mistakes in Europe as well as in the US, have risen in recent months and Europe could experience at least a mild recession.
“A decrease in US consumer spending is another threat to the global economy,” he said. Since the start of 2008, overall US disposable income has risen by approximately $775 billion, supported by reduced consumer savings and government stimulus. Approximately $550 billion, or around 70%, of the increase in US disposable income has come from an increase in government transfer payments.
“The good news — which has been largely ignored recently— is that in the absence of a European meltdown, most of the global economy has been improving,” he said. “The most recent measures indicate that growth in the US, other developed countries and emerging markets is stabilizing, albeit at a below trend level.”
At the same time, Koesterich puts the chances of a global recession next year at 35% to 40%, compared with just 20% last year.
“While US economic data has stabilized, political paralysis in Europe continues to be a major risk factor, threatening not just Europe but also the broader global economy,” he said.
He sees just a 5% chance that the world will return to stronger growth next year. “A quick acceleration in global growth appears unlikely because, among other reasons, Europe is almost certain to undergo at least a mild recession,” said Mr. Koesterich.
With recent improvements in global economic data, the ongoing recovery— though still quite fragile— appears sustainable, although Europe remains a notable risk, Koesterich said. “Even if Europe can avoid a sovereign debt collapse, the deleveraging by the European banking system is likely to produce at least a mild recession in 2012,” he said.
In other parts of the world, growth should be better, but still below trend. The US economy is likely to grow approximately 1.75% to 2.50%, an improvement over 2011 and in line with average growth rates from the last decade. Smaller developed markets, such as Canada, Australia, Singapore, Switzerland, and Hong Kong (the CASSH markets), are expected to grow significantly faster, along with most emerging markets.
Japan is likely to be the fastest growing of the major economies, given reconstruction from last year’s earthquake and the Japanese banking system’s relative stability.
“If the European crisis does not worsen, the broader global economy can avoid another contraction. Absent a worsening European crisis, we hold a positive longer-term view on equities, particularly relative to bonds, and we believe that investors should take advantage of historically low equity valuations and increase allocations to smaller, developed countries and emerging markets,” he said.
“While the recovery should continue in the absence of another crisis, the odds of an exogenous shock have increased on two fronts, both related to policy,” Koesterich said.
“The lack of a long-term plan to stem European sovereign debt contagion raises the odds of a banking crisis, severe recession and even the dissolution of the Euro,” he said. “All this could undermine global confidence and trade, and arguably put significant strains on the global banking system.”
“If there is a reversal in the savings rate or the stimulus provided in 2011 is not extended into 2012, consumption is likely to fall,” Koesterich said. “In the absence of an unlikely pickup in the labour market and real incomes, temporary sustenance is probably the best we can hope for in 2012.”
“The start of a new year is always a good time to review your investment goals and asset allocation with your financial professional, and to make portfolio changes where necessary. Reflecting the potential outcomes for 2012,” he said.
Koesterich suggests a “barbell investment approach” comprising a portfolio roughly weighted to the two main scenarios of the “Great Idle,” representing 60% of an investor’s portfolio, and the “Global Double Dip”, representing 40%. The weightings could be adjusted during the course of 2012 according to whether signs of stabilization or downturn emerge.
As a baseline, Koesterich favours maintaining a core position in global, dividend-paying mega cap stocks to address both scenarios. Investors should consider smaller developed markets such as Canada, Australia, Switzerland, Singapore, Hong Kong, and select emerging markets such as Latin America.
In fixed income, Koesterich believes corporate bonds, particularly in the investment grade sector, are undervalued.
“The spread between yields of Treasuries and US corporate bonds looks unusual based on historical averages, recent trends in credit quality and in the context of the current economic climate,” he said.
For the “global economic recession” portfolio, Koesterich suggests exposure to US Treasuries, even given the risks associated with US debt. He also favours maintaining a relatively small strategic weight to gold, despite its volatility.