Focus on yield, quality and diversification as safe havens contract

Global economic growth, at 3.6%, will be led by emerging markets. U.S. growth will improve slightly, rising to 2.1%, while China will benefit from a soft landing, comments Mr O?Neill.

World economy on the brink – but slump can be averted

The pressing need for mature economies to reduce debt, combined with weak business spending and soft asset prices, threatens to result in a global recession. However, a worldwide slump can be avoided, according to the Merrill Lynch Wealth Management Year Ahead 2012 analysis. China?s growth is expected to slow but experience a soft landing as the authorities move to reflate early in 2012.

“We see the Chinese economy expanding by 8.6% in 2012, compared to an expected 9.2% last year,” says Mr O?Neill. The main risks to China?s economy are higher inflation or slower investment. India and Russia should maintain their strong growth of 2011 (full year 2011 growth is expected to be 7.0% and 4%, respectively).

The U.S. Federal Reserve is likely to support the housing market to combat high unemployment and to keep rates flat until at least 2014, comments Mr O?Neill. Consumers across the G5 (Canada, the Eurozone, Japan, the U.S. and the U.K.) will benefit from an easing of inflation. The G5 economies should continue to grow in a meagre fashion, collectively by 1.1%, below the expected 1.3% in 2011.

A disorderly Eurozone sovereign default and/or withdrawal from the common currency head the major risks. Other potential negatives include continued policy paralysis in Europe, contagion to other regions from Eurozone deleveraging, possible currency wars, the risk of bank runs (a rapid withdrawal of deposits by investors) and over-zealous fiscal austerity. Europe is a candidate for possible positive surprises too, says Mr O?Neill.

First, the European Central Bank (ECB) could move more quickly than expected to monetise sovereign and bank debt, however, there is a chance that such a response comes only after further damage has been done to growth prospects in the Eurozone. Second, an unexpectedly deep rate cut by the ECB to 0.5% may also improve the region?s outlook. The combination of a weaker Eurozone economy and a more active central bank will likely lead to a weaker euro in 2012. A depreciated currency should provide a support for the region in the face of weak final domestic demand.

A weak consumer and ripples from the Eurozone will likely force the Bank of England into further quantitative easing – but this might not prevent the U.K. entering recession in the first half of the year. “While current economic challenges are very different from those experienced in previous cycles, 2011 exposed the responses of policymakers as inadequate. A lack of internal and external coordination has been one of last year?s major disappointments,” says Mr O?Neill. “Improving global coordinated responses to indebtedness could give a major boost to the Eurozone and world economy.”

Focus on yield, quality and diversification as safe havens contract

Against the backdrop of fragile growth, investors are worried about the risks of even greater disappointment, according to Merrill Lynch Wealth Management?s Year Ahead 2012 analysis. “The task of ensuring diversification across investment portfolios is complicated by a shrinking set of „safe havens?,” says Mr O?Neill. “We are stressing yield, quality and growth in selecting equities.”

“In selecting equities in 2012, we are recommending a focus on large cap companies with strong cash flow and growing dividends,” Mr O?Neill says. “We urge caution but do not foresee catastrophe this year and continue to stress the need for a strategic framework to deal with „new normal? conditions of slow growth and higher risks. This includes anticipating periodic bouts of substantial losses, volatility bubbles and frequent switching between „risk on/risk off?.”

Merrill Lynch Wealth Management EMEA recommends overweighting U.S. and U.K. to be most effectively positioned for this environment. U.S. large caps are the top pick, reflecting their more reliable performance in meeting analysts? earnings forecasts than peers elsewhere.

Consumer discretionary, consumer staples and information technology are the three preferred sectors. These areas offer the best combination of earnings quality, valuation and alignment with the macro environment. Merrill Lynch Wealth Management EMEA also favours broad growth themes, including the emerging market consumer and global infrastructure. “We await policy easing in China before increasing emerging market holdings,” says Mr O?Neill.

Merrill Lynch Wealth Management EMEA also recommends being underweight both Eurozone and Japanese equities in 2012. While Japan?s growth should recover in 2012, corporate earnings are likely to disappoint. Eurozone equities are cheap and sentiment toward them is already at rock bottom, but Mr O?Neill warns it is too early to invest in the region due to its high risk.

In fixed income, investors should prefer credit to sovereign investments. This includes both investment-grade and high-yield corporate bonds, with a preference for U.S. companies. A tolerable level of defaults is already priced into the high yield market. Investors should particularly avoid sovereign and bank exposures in peripheral Eurozone economies.

“Attractive credit spreads price in a significant increase in defaults which in any case we do not expect. Core sovereign bonds remain unattractive in all scenarios, other than a prolonged global recession,” says Mr O?Neill.

Commodities growth to ease; U.K. property offers opportunity

Expectations of lower inflation reduce commodities? appeal. Two of 2011?s strongest performing assets, gold and oil, are unlikely to replicate these returns in 2012. While supported by very low real interest rates, gold is likely to be held back by the U.S. dollar?s strength; however, an aggressive quantitative easing programme could provide a catalyst for a considerable move higher, perhaps to breach the $2,000 per ounce mark. Controlled supply should limit crude oil?s potential decline.

“We do not preclude adding commodities exposure if China reflates sooner than we expect. Industrial metals such as copper would be notable beneficiaries,” says Mr O?Neill.

Commercial real estate, specifically in the U.K., could provide sound income opportunities in 2012. The focus is very much on the prime sector. Polarisation between prime and good secondary property, and lower quality assets will continue, according to Merrill Lynch Wealth Management EMEA.

Three years on from the 2008-9 financial crisis, investors are once again confronted with deep discounts in the value of assets linked to this very atypical business cycle, says Mr O?Neill. “In 2012, despite shrinking opportunities for portfolio diversification, investors should focus on yield and quality, while aligning their portfolios to allow critical longer term growth themes to be captured.”