The global economy in 2012 will likely remain in a so-called "Great Idle," with slow, positive growth and an economic crisis avoided, according to Russ Koesterich, Global Chief Investment Strategist for BlackRock's (NYSE: BLK) iShares business.
Koesterich assigns a 55% to 60% probability to a "Great Idle" scenario. However, the odds of another global recession – the result of policy mistakes in Europe as well as in the U.S. – have risen in recent months and Europe could experience at least a mild recession.
"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 U.S., 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 U.S. 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, largely because of the near-certainty that Europe will slide into at least a mild recession. "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 U.S. 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," Koesterich said. "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."
That 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.
"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."
A decrease in U.S. consumer spending is another threat to the global economy, Koesterich said. Since the start of 2008, overall U.S. 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 U.S. disposable income has come from an increase in government transfer payments.
"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," Mr. Koesterich said. "In the absence of an unlikely pickup in the labor market and real incomes, temporary sustenance is probably the best we can hope for in 2012."
Reflecting the potential outcomes for 2012, 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.
This approach would entail maintaining a core position in global, dividend-paying mega cap stocks to address both scenarios with attention paid to smaller developed markets such as Canada, Australia, Switzerland, Singapore, Hong Kong, and select merging markets such as Latin America.
In fixed income, corporate bonds, particularly in the investment grade sector, are undervalued. The spread between yields of Treasuries and U.S. corporate bonds looks unusual based on historical averages, recent trends in credit quality and in the context of the current economic climate, Koesterich notes.
For the "global economic recession" portfolio, Koesterich pointed to exposure to U.S. Treasuries, even given the risks associated with U.S. debt. He also supported maintaining a relatively small strategic weight to gold, despite its volatility.
Three scenarios and potential investment strategies for 2012
Here is a summary of Mr. Koesterich's three possible scenarios and potential investment strategies for 2012:
Economy remains in the "Great Idle"
Probability: 55%-60%
What it looks like: Growth remains anemic, but crisis avoided
Potential strategy: Overweight high-dividend mega-cap stocks, smaller developed markets, emerging market equities, and corporate bonds
Crisis and global double-dip recession
Probability: 35%-40%
What it looks like: Policy failure in Europe leads to a banking crisis and severe recession. Fiscal austerity in the U.S. slows growth.
Potential Strategy: Overweight U.S. Treasuries, gold, and global mega caps
Growth accelerates
Probability: 5%
What it looks like: Emerging markets resume stellar growth and the developed world reverts to its long-term mean
Potential strategy: Overweight European equities, emerging markets and cyclical stocks. Underweight U.S. treasuries
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