KUWAIT – The whole world is slowing down. The US economy is showing signs of deceleration and could enter a soft patch. Consumers are cautious. Europe - UK included - is sliding into recession. China and India are unlikely to inject a sizeable stimulus in their economies. Going forward, growth will remain challenged. In advanced economies, household, financial-sector and public-sector deleveraging, spending cuts and reforms are needed and upcoming. Fiscal consolidation will accelerate disinflation, and - as buyers anticipate lower prices - consumption will decline. "Tail risks" - low-probability, high-impact events that could have systemic consequences via negative feedback loops - could materialize, hampering the real economy and investor confidence, said Alessandro Magnoli Bocchi, chief economist and member of the management team at the KuwaitChina Investment Company. Indeed, global unemployment affects 200 million people (up 27 million since the start of the crisis) and could spark unrest. The Arab turmoil and Iran nuclear ambitions are unlikely to be frictionless. The eurozone's democratic deficit, rising sovereign risks and ongoing debt restructuring are sources of stress and possibly contagion. Policy mistakes, due to wait-and-see attitude or political deadlock, could induce a recession. Banks, in need of capital and allergic to regulatory reform, will foster financial sector jitteriness. Global politics look challenging, with presidential elections in the US, Russia, Yemen, and Venezuela, parliamentary elections in India, Iran, Libya, Jordan, and Tunisia, the leadership transition in China and North Korea's succession. Pakistan and Afghanistan could also contribute to geo-political instability, Bocchi said in his commentary. As a result, corporations are on hold, lacking confidence to make significant business and investment decisions, since sales, profit margins and corporate earnings might suffer. The market seems to have moved ahead of fundamentals, and a correction looks likely. In 2012, because of excessive liquidity and high uncertainty, stock markets are likely to remain highly volatile. Investors might focus on news and events rather than longer-term trends. Given the slow-growth, disinflationary outlook, a fast "reversion to the mean" of returns is improbable. Indeed, stocks could be cheap because, as happened in Japan, they discount a deflationary trend. Taking fundamental directional bets (i.e. via long-only funds) is likely to prove disappointing. Earnings growth will soften, especially in emerging markets. Financials are likely to suffer. Investors will privilege strong balance sheets and value. Blue chips income-producing multinational brands will do well, as a significant share of their revenues comes from emerging markets. Small luxury companies, healthcare providers and the consumer sector are likely to generate returns. US stock markets are likely to outperform. Core sovereign bonds (US Treasuries and German Bunds) might benefit from risk-off episodes, slowing economic growth and a reduction in long-term interest rates. Still, in absence of systemic shocks, high-yield corporate credit might perform well and emerging country bonds denominated in local currencies could deliver even higher returns. Inflation-linked bonds show more risk than returns. The unfolding of the eurozone crisis and the ongoing ECB monetization should weaken the euro. If a tail risk materializes, investors will retreat to the US dollar, still the world's primary trading and reserve currency and a global safe haven. The Swiss franc is likely to maintain it purchasing power. With respect to the past decades, investors face a very different, and more difficult, investment environment. The probability of future financial shocks, and black swans, is high. Capital preservation via a defensive asset allocation is priority. Over the next couple of years, cash could work as both an insurance against sharp downturns and the required seeding-capital to quickly seize opportunities. Still, in the longer-run, keeping liquid portfolios will result in low returns. Illiquid assets, such as private equity and real estate are to be considered, but only if fully understood and professionally executed. In a few years, looking back to this post-crisis period with the benefit of hindsight, it is likely that unusual portfolios - less liquid and more volatile, thus considered of lower quality today - will perform better than accepted ones. – SG
