Storms, patches of blue

The worst-case scenario is a blow-up in the U.S. or Europe that spreads rapidly, creating another global credit crisis.

Best case is U.S. growth of 3%-3.5%, early resolution of Europe’s debt problems and a soft landing in China.

Financial markets are worried, which is creating extreme volatility as everyone tries to figure out what’s going to happen. Every piece of good or bad news — and hardly a day will pass without one or the other — will move markets.

The medium-term outlook is not bright, either, even if near-term disaster is avoided. Both the U.S. and Europe probably face years of sluggish growth because of the tax increases, spending cuts and lowering of social benefits that will be required before those economies will be able to grow at healthy rates again. Japan has been mired in a similar situation for 20 years, treading water because it doesn’t have the political will to open up the economy to foreign competition.

The only regions that can keep the global economy moving at a decent pace are the emerging markets, led by China. Assuming China avoids a hard landing, its growth in the coming years is expected to be around 8%, down from the 10%-plus of the previous decade but enough to keep the global gears moving. Some deceleration in China is inevitable as it grows richer and more mature.

It appears this is a terrible time to invest — but that’s far from the case. Global investment fund portfolio managers and strategists say the volatility is creating many investment opportunities. Even pessimists see lots of possibilities, while value managers, who normally take a buy-and-hold approach, are finding deals everywhere.

“Every time stocks get beaten up, value is created,” says Don Reed, president and CEO of Toronto-based Franklin Templeton Investments Corp., a value manager. “Even in expensive markets, we are finding value.”

Below is a look at the factors that will determine how the major regions will fare in 2012, and where portfolio managers and strategists see potential investment opportunities:

l the u.s. This economy has been producing better than expected data for the past six months, leading most analysts to expect moderate growth of 2%-2.5% this year and encouraging a few to believe that U.S. growth will surprise on the upside, at 3%-3.5%. However, there are doubters, who think this situation is just the sputtering of a machine that is so overloaded with debt that it can’t generate sustained growth and could slip into recession.

Supporting the view of continued U.S. growth is that economy’s long history of resilience, continually surprising on the growth front as a result of strong productivity growth and consumers who will spend at any opportunity. Lloyd Atkinson, an independent financial and economic consultant in Toronto, points out that the U.S. is a much more flexible and adaptable economy than Europe, Japan and other industrialized countries, including Canada.

In addition, the U.S. housing market has dropped so far that it can’t fall much further, and any improvement not only will contribute to growth and employment but would boost consumer confidence. Inventories are so low that new production will be needed for any increase in demand. Balance sheets for non-financial corporations are in such good shape that those companies could start hiring and increasing capacity quickly — as soon as they are confidant demand is increasing.

Furthermore, Americans have already increased their savings rate, so they can continue to pay down debt without squeezing their spending.

The counter argument is that the U.S. has reached the limit of debt that its consumers and Washington, D.C., can carry. Ross Healy, chairman and CEO of Strategic Analysis Corp. in Toronto, believes the U.S. is in what he calls a “second-order insolvency,” which means it can’t raise enough revenue to pay the interest on its debt, so its debts keep mounting. In Healy’s view, the only way out is to sell major assets, mainly infrastructure such as roads, ports and airports.

Nandu Narayanan, chief investment officer with Trident Investment Management LLC in New York and manager of a number of funds sponsored by CI Investments Inc.; and David Rosenberg, chief economist and strategist with Gluskin Sheff & Associates Inc. in Toronto, don’t go this far. But both believe there’s too much consumer debt to generate much consumer spending this year and, indeed, for years to come. Narayanan expects a return to recession in the U.S. in the second half, while Rosenberg thinks that economy will probably just tread water.

Supporting this negative view is the U.S. banks’ reluctance to lend. Most of the liquidity from the first two rounds of quantitative easing — with the U.S. Federal Reserve Board buying bonds from financial services institutions — is sitting on the banks’ balance sheets and not generating economic activity through loans to businesses and consumers. As long as the banks don’t increase their lending significantly, it’s hard to see the U.S. economy picking up speed.

Markets have priced in U.S. growth of 2%-2.5%. Higher growth obviously would result in enhanced returns, but significantly less growth could lead to a substantial stock-market correction and possibly a crisis in the bond market or the US$.

Financial markets are already frustrated by the political gridlock in Washington that is preventing development of a credible plan to eliminate the U.S.’s big fiscal deficit and the increasingly huge mountains of debt until after November’s presidential election. For now, markets remain distracted by the European sovereign-debt crisis and have put concerns about the U.S. on the back burner. But will that last?

The answer isn’t clear. If the U.S. manages to grow by 3%-3.5% this year — as is expected by Atkinson; Drummond Brodeur, global strategist at Signature Global Advisors, a division of CI in Toronto; and Jean-Guy Desjardins, chairman, CEO and chief investment officer with Fiera Capital Inc. in Montreal — markets will probably wait it out.

If the U.S. chugs along at a modest 2%-2.5% — the consensus view — markets also will probably take a wait-and-see attitude but will be jittery and could lose confidence, particularly if it looks as if U.S. President Barack Obama will be re-elected; with a Republican-dominated Congress and Senate, that situation would prolong the political gridlock.

If the U.S. slides back to anemic growth or into recession, the odds of a big stock-market correction and possibly a bond-market or US$ crisis increase significantly.

Not surprisingly, pessimists such as Healy, Narayanan and Rosenberg don’t recommend U.S. stocks, except possibly U.S. multinationals with significant exposure to emerging markets.

The other economists and portfolio managers Investment Executive spoke with are quite enthusiastic about U.S. stocks, feeling that valuations are at attractive levels — although the “modest growth” camp has a distinct preference for the relatively safe multinationals and defensive sectors. (See page B18.)

l eurozone. Southern Europe is in the grip of a recession while the north is still growing, albeit tepidly. For the region as a whole, most analysts think there will be an economic downturn, although a relatively mild and short-lived one.

However, there are some optimists. Reed and Peter O’Reilly, head of the global equities team with I.G. Investment Manage-ment Ltd. in Dublin, think Europe will scrape through without a regionwide recession. Both analysts put their faith in the US$500 billion that the European Central Bank is injecting into the eurozone’s banking system and the funds available for governments from the European Stability Fund (US$500 billion) and the International Monetary Fund (US$400 billion).

Those cash injections should keep the eurozone growing as long as the banks lend the funds they receive rather than sitting on them, as many U.S. banks are doing.

More important, the recap-italization of banks and the availability of loans for governments should ease concerns about a credit crisis in Europe. Although Desjardins foresees a recession in Europe this year, he thinks markets will no longer be worrying by mid-year. Reed and O’Reilly agree that such concerns should abate during the year, although they aren’t precise on the timing.

Other analysts aren’t as confident of an early resolution to the crisis but assume the politicians will come to an agreement that all — or, at least, most — can live with, simply because the costs of not doing so are too high.

There may be some defaults. For example, Charles Burbeck, head of global equities with the wealth-management division of Barclays Bank PLC in London, expects Greece to default. Healy thinks there will be others as well.

But that is manageable. “If Greece defaults, it’s not the end of the world,” Narayanan says. “And it wouldn’t even have to leave the European Union.”

In the meantime, many portfolio managers and strategists are underweighted in Europe except for multinationals that sell worldwide, including to China and other emerging markets. These experts are particularly down on European financials.

Desjardins, Reed and O’Reilly are the exceptions. They recommend buying European bank stocks and some government bonds, in the anticipation of strong gains as soon as market concerns abate. O’Reilly suggests Italy’s bonds, feeling that the 7% coupon is not justified, noting that Spain’s bonds are at only 5%.

Desjardins also suggests buying euros, as he expects the currency to rise in value when market concerns abate.

O’Reilly is less enthusiastic. He can see some strengthening in the euro as market concerns abate but expects the currency to be lower by yearend.

l asia. A hard landing in China would be disastrous for everyone. China, the world’s second-largest economy, is a major driver of global economic growth. Portfolio managers and strategists believe this economy can grow at around 8% this year as long as the U.S. doesn’t falter and Europe has only a mild, short recession.

If China’s pace sinks to 7% or less, the country will be importing less — to the detriment of exporters everywhere. Everyone sells to China, including other emerging economies. Europe is a major exporter to China, and many U.S. multinationals depend on sales to China and other emerging markets for much of their revenue growth.

Japan, Canada and other major resources exporters, including Australia, New Zealand and the Scandinavian countries, would be particularly hard hit. Exports are about all Japan has going for it, and China accounts for more than 50% of those sales.

China is also responsible for the current high resources prices, which, analysts are assuming, will continue after some weakening in the first quarter. Without good growth in China, there could be big drops in the prices of oil and base metals

All the analysts are assuming that China will avoid a hard landing. Most are counting on easing monetary policy and the cash-rich government’s ability to put fiscal stimulus, if needed, in place quickly.

Hugh McCauley, managing director and lead portfolio manager with Acuity Investment Management Inc., owned by AGF Management Ltd., is the most adamant, giving the odds of a hard landing in China zero probability. He explains that a major transition of political power will take place late this year, and every effort will be made to ensure the transition is not impeded by weak growth. China’s authorities are well aware of the uprisings in Africa and the Middle East in 2011 and know that the potential for the same exists in China.

Assuming China makes it through this year without a hard landing, its economy is expected to continue growing at a fast pace, although some analysts think the pace will probably slow. McCauley, though, thinks Chinese growth will continue to surprise on the upside because industrialization and the move to urban centres is just gathering steam in the much more populous interior of the country.

With healthy growth, inflation will continue to be an issue in China and other emerging markets. However, the evidence of the past 18 months suggests these countries can manage that.

Many portfolio managers favour exposure to emerging markets but warn that these equities could be side-swiped this year, as they were in 2011, by risk aversion in the form of a flight to the safety of assets denominated in US$, which is still the world’s reserve currency. That doesn’t make emerging-markets investments a bad idea, but your clients probably should have a medium-term time horizon if they want to load up.

Direct investing isn’t the only way to get emerging-markets exposure. Other routes include multinational companies that sell in these countries; resources equities, whose earnings benefit from continued growth in these regions; and resources-producing economies, whose growth is enhanced by strong resources prices.

The last group includes Cana-da. Quite a few global portfolio managers who aren’t based here, including Burbeck, O’Reilly and Narayanan, all recommend overweighting Canada and other resource producers — and not just through resources equities. Canadian banks are particular favourites, given their excellent balance sheets and this country’s growth prospects.

Yet another way to benefit from emerging markets’ growth is through bonds. These countries have much higher inflation than the industrialized world, so their government bonds pay much higher coupon rates. You could consider limited exposure for your clients in these regions.  IE