While consensus forecasts for next year continuing to be muddle-through mediocrity with a crashtastic defensive bias, BofA Merrill Lynch provides a very succinct outline of the bullish, bearish, and interestingly secular cases for risk assets going forward. The cross-asset class implications are noteworthy and provide an excellent jumping off point for asset allocation decisions. We are not sure the seeming knife-catching perspective of "buying humiliation and selling hubris" will work out, but one thing is for sure, with this volatility, relative-value remains the critical alpha as beta chops everyone up.
The bull, bear and secular cases
With many forecasts for existing trading ranges across asset classes to hold in 2012, we highlight the tail risks that could cause major bull or bear markets, and catalysts to watch for.
The bull case for 2012
The upside risk to markets comes via a credible, coordinated policy response (ECB QE + EU fiscal contraction + Fed QE3 + China ease), and/or a recovery in the real estate, banking and labor markets. The latter would allow the Fed to raise interest rates, resulting in a “good” bear market in bonds (Chart 7). This in turn would unlock a secular bull market in equities, and allow the MSCI ACWI to break above 375 next year. Equity leadership would likely come from Developed Market (EU + US) bank stocks, Asian industrials, Japanese autos, and EM resources.
Catalysts to watch: US initial weekly unemployment claims dropping below 375k, boosting the domestic demand story; meaningful declines in EU sovereign debt spreads driven by a pro-active ECB; a supply-driven slump in oil prices.
The bear case
The key downside risk to markets would be a major banking and debt crisis in Europe that triggers a recession in the US and a hard landing in China. In this scenario earnings growth would likely have double-digit declines, and Financials would take another leg down. Bonds would outperform stocks and we would expect the MSCI ACWI to fall to 225. Within equities, this would be very negative for US cyclicals such as Tech and Resources, EM consumer stocks, and global energy stocks.
Catalysts to watch: A collapse in the Euro that kills US Tech earnings; EU bank deleveraging causing a slump in China/Asia export growth and currencies; a quick end to the current “deflationary recovery” in US consumption.
The secular case: buy humiliation, sell hubris
While the focus is on 2012, we offer a quick word on the longer-term outlook for equities.
Despite our short-term caution, in our view equities on a 2-3 year view appear compelling. Investors enter 2012 in a fearful state, but in our opinion any sharp declines in equities in 2012 should be bought. The ingredients for equity outperformance over the medium term are being put in place, and 2012 could represent the beginning of the end of the great bear market in equities. Companies are in immaculate shape, US consumer deleveraging is already under way, public sector deleveraging will accelerate dramatically in Europe, and political change is likely in 2012 in many countries.
Further, fixed income valuations may soon become bubble-like versus equities (Chart 9), and extreme volatility and correlations are destroying any public interest in equities. The secular hubris is in fixed income, not equities.
And the broad cross-asset class implications of these views are summarized in the following large table:
Once again the bull case relies heavily on government printing presses and the bear case on the reality of debt saturation breaking through.