European debt crisis, recession fears will challenge TSX in 2012

And none of the problems that have spooked investors for months are going away any time soon — a worsening European debt crisis that threatens to drag the continent into recession with spillover effects affecting everyone from China to Canada and the United States.

How much worse could it get?

Markets could fall a lot, says portfolio manager Danielle Park. In fact, she wouldn’t be surprised to see them retest their lows of March 2009, when the TSX hit the 7,567 level.

That would be a whopping 4,000-point drop from the where the main Toronto index stood in the last weeks of 2011.

“The main theme is the slowing global economy,” says Park, who works at Venable Park Investments in Barrie, a central Ontario city north of Toronto.

“We haven’t had a recession confirmed yet, so you don’t get a bottom in the market until you have had confirmation of a recession. And from that point, you tend to lose about 75% of what the overall losses end up being.”

Most economists predict the Canadian economy will grow by less than two per cent in 2012 as it deals with weakness in Europe, slow growth in the United States and slumping commodity prices.

That sluggish economic performance won’t help create many new jobs for the country’s 1.4 million unemployed or lower the 7.4% national jobless rate.

If the global economy actually contracts, another recession would produce millions more jobless workers around the world and weaken or wipe out corporate profits — a main driver of rising stock prices.

Park’s firm has been out of the stock markets and “right now, we’re in the U.S. dollar and bonds, all of which have made money year to date, and we’re looking for another important buying opportunity, probably in 2012.”

She says it’s a good time to keep money liquid to take advantage of the next buying opportunity after the market finds a new bottom.

“Half of your money should be in high quality Canadian deposits like GICs or short Canadian bonds,” she says.

“You can have up to 30% of that in U.S. Treasury bills because the Canadian dollar is weakening as we head into this next downturn and I think you’re likely to see that continuing for the next few months, which means you can make some great gains just holding US T-bills with no market risk at all.”

Park also emphasizes that there is nothing wrong with exiting the market now and waiting until the worst is over.

“Absolutely, we have been out of the market all year,” she said.

“It’s not too late. We haven’t had confirmation of a recession yet. Until we do, you won’t see how far this market is going to go down.”

Park is not alone in fearing that recessionary conditions will make it tough for markets in 2012.

“We’re in a cyclical bear market, so there’s another big down-leg in the markets next year,” said John Johnston, chief strategist at Davis Rea Ltd., a Toronto-based money manager.

“There is a recession out there, and one wants to be careful.”

The TSX did much worse than U.S. markets in 2011, reflecting steep losses in the mining, energy and financial sectors, whereas the S&P 500 finished the year down 2.9% and the Dow industrials actually gained about 2.5%.

Since the TSX passed the 14,000-point level almost 10 months ago, the market has faltered steadily. The problem in Europe came more and more to dominate market sentiment as the crisis steadily worsened and governments adopted increasingly tough austerity measures in order to deal with massive debt levels.

Investors also grew increasingly frustrated at the apparent unwillingness on the part of politicians to come up with a convincing plan to deal with it quickly.

Most EU countries agreed in December to frame a new treaty that would see a central authority overseeing their budgets and impose tighter controls on spending.

But such a move will be a lengthy process and there was deep disappointment that more wasn’t done to reassure financial markets now, such as the European Central Bank stepping up to ramp up purchases of bonds from heavily-indebted countries like Italy and Spain as a way of keeping borrowing costs lower.

“It leaves us with a short-term problem and that is clearly what the market has returned to worrying about,” says Kate Warne, Canadian markets specialist at the Edward Jones brokerage in St. Louis.

“The policy-makers don’t have the luxury of time they would like and markets are very demanding that something happens sooner rather than later because they have let this play out far too long.”

It is hard to see how any of the TSX stalwarts can push the market higher in 2012 as commodity prices likely weaken and bank profits go nowhere.

For example, China has been a huge pillar of growth for the global economy, and the resource-heavy TSX, amid strong double-digit growth. Its huge demand for oil and metals supported strong gains in energy and mining stocks but growth has dipped to the high single digits as the Chinese government deliberately slowed the economy in order to deal with high inflation, particularly in food prices.

China’s government earlier this month announced plans to ease lending for the first time in three years in order to encourage growth. But Chinese demand for commodities will likely be stunted because of slowing exports to Europe, the country’s biggest market, where many countries are already back in recession.

“They realize they can’t be quite the export juggernaut they were if a lot of the world they export to is rolling in so much debt and can’t grow and can’t pay for it,” says John Stephenson, portfolio manager at First Asset Funds Inc.

As for Canadian banks, they had a tough 2011, losing ground in a difficult environment for their capital markets divisions and getting caught up in the general fear over what a disorderly default in the eurozone would mean for the global financial system.

“You’re going through a global banking crisis here,” says Johnston.

He also points out that Canadian banks face headwinds domestically as a worsening economy could drive up the jobless rate, throwing heavily indebted Canadians out of work and rendering them unable to pay bills.

Meanwhile, even the most optimistic expectations are modest in the extreme for the Toronto market this year.

“Despite a year of economic difficulties in Europe, I’m confident the stock markets will advance in 2012,” says Bob Gorman, chief portfolio strategist at TD Waterhouse.

“We will likely be in a relatively low growth, low inflation environment that should favour large cap stocks, which generate a good part of total return from substantial, rising dividends.”

Gorman sees moderate growth both for the economy in general and corporate profits, which would yield a TSX gain in the upper-single digits.

“Less economically sensitive sectors should be among the better investments in this environment, with dividend growth stocks providing solid income and total returns,” he says.

Gorman also sees improved results for emerging markets in 2012, which in turn would be good for the TSX if countries like China do need to load up on more oil and metals.