Outlook 2012: Part 2

The majority of the world’s Leading Economic Indicator (LEI) indexes are not pointing towards a recession. Of the 29 countries within the OECD (Organization for Economic Co-Operation and Development), 12 are currently showing LEI levels of 100 or better, indicating (expansion). Importantly, one non-OECD country that is showing expansion is China. In fact, the world’s three largest economies (individual countries) are showing LEI levels indicating continued expansion (U.S., China and Japan).

However, there are a number of economically significant countries whose economies are slowing. The following are major countries that appears to us to be showing LEI levels at less than 100 (expectations of a slowdown in growth/contraction):
 Canada
 United Kingdom
 Germany
 France
 Switzerland
 Brazil
 India
The LEI data, while mixed, still points on balance to a continuation of growth, albeit on a choppier, non-systemic basis.

Slowing Industrial Activity

On the other hand, we are seeing evidence of economic stresses that are starting to occur due to the significant economic slowing occurring in Europe. World-wide economic momentum, particularly in the industrial segment, seems to be slowing. Indeed, the year-to-year percentage change in J.P. Morgan’s Global Manufacturing PMI Index shows a contraction of 4.7 percent, as compared to expansion at the beginning of 2011.

On a worldwide scale, the only major economies which are showing positive manufacturing readings are the U.S., Switzerland, Japan, India and Australia. All other major economies’ manufacturing bases are showing weakness, on the margin, with particular current weakness observed in the Europe and China.

The Bottom Line for 2012

So where does this leave the world’s economy? Looking specifically at the world’s “income statement” items we paint a picture which is weak, on balance, but still positive. We expect the world to witness the following during 2012:

 Weaker growth but no recession. We expect to see slightly slower economic growth during 2012 vs. 2011. Worldwide economic growth (real) increased at roughly 2.6 percent during 2011. We expect a slower growth rate to emerge during 2012. However, the world should stay out of recession (defined here as growth less than 2.0 percent).

 A shift in growth to favor the U.S. In addition to a slightly slower economic growth rate, we believe the composition of that growth rate will change. Major geographic segments under growth pressure during 2012 as compared to 2011 include Europe, China and the rest of the emerging economies. Areas where growth may accelerate (in some cases only slightly) include North America and Japan.

 Emerging market growth continues. We believe China and many emerging markets will outgrow the vast majority of the world. However, we expect overall emerging market GDP growth to weaken.

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 European stagnation. Although a global recession is unlikely, some of major geographic segments are likely to see economic contraction. The most notable of these will be Europe. We are calling for GDP growth in Europe to fall by 1 percent during 2012. This contraction may have a significant impact on worldwide economic performance during the year.

 Age of austerity. Consumer marginal demand will likely be slow, driven by higher-than-normal unemployment rates and existing high levels of outstanding debt. We are living through an age of deleveraging. This is true of both the U.S., and Europe. We feel consumers and governments will need to continue paying down debt to satisfy credit market demands.

 Global inflation should decelerate. This is not due to welcome reasons, slower final demand growth rates coupled with high levels of economic and political uncertainty. Businesses have been “sitting on their hand” over the last few years due to these trends, which may continue in 2012.

 Commodity prices (industrial) may be weak. Growth in major commodity-importing countries will be contracting, albeit from high levels.

 Job scarcity continues. Unemployment in major developed economies should remain elevated compared to historical norms.

 Sovereign interest rates should remain subdued for “safe” countries. We believe investors will pay a premium for sovereign debt that appears to be high quality (U.S., Switzerland, Germany and others) or is issued by countries which have a lack of leverage on their sovereign balance sheets. Other governments which do not possess either of the above characteristics may need to “pay up” for capital during much of 2012.

 Economic uncertainty, political anxiety. Uncertainty will be accented due to monetary, banking and currency system dislocations. Politically-generated volatility may remain high on investors’ source of anxiety. This is particularly true in the U.S. and the Euro area, especially France and Russia.

Balance Sheet Concerns and Our Longer Term View

While the world’s economic environment seems rather benign, real issues still infect most people’s view of risk taking and the sustainability of economic growth. We have written extensively on these issues since 2007. The problems have manifested themselves into levels of excessive debt that has been created due partially to a lack of strong economic growth rates to fund rising governmental and lifestyle activities.

There are two ways of funding increasing spending by any economic unit; by earning the money or borrowing the money (or in the case of a central government, printing the money). If the economic unit borrows the money, the lender of this capital needs to be repaid when due.

A Final Word

With all that is happening in Europe, and Washington and the underlying issue of economic power transfer from the developed countries to the developing countries, why in the world would a U.S. investor consider raising their risk profile? Complete risk aversion has never been a rewarding long-term strategy in investing or life. Being an investment Candide in this global environment also lacks credibility.

We feel the market is potentially at the start of a long-term process in which there could be more light than darkness. Given the background we have outlined, it makes sense to us for equity investors to consider downside volatility, when it occurs, as an opportunity rather than a cost. To do so, some candid, serious questions about the market should be asked. It is a healthy process that, in our opinion, needs to start. And why now?
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