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December Review and 2012 Outlook January 9th, 2011 By Kim Mailey, CFP

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The Frustrations of 2011

2011 was a volatile and disappointing year for most investors. Expectations entering 2011 featured a continuation of the economic recovery around the world following the Great Recession of 2008. Debt and credit issues, however, obviously exploded over the past year, particularly in Europe. The investment landscape was one driven by fear and anxiety and while corporate earnings were up in most places, price earnings multiples were down, causing equity markets to struggle.

	1 Year	3 Year	5 Year	10 Year
S&P/TSX Composite Index	- 11.1%	+ 10.0%	- 1.5%	+ 4.5%
S&P 500 Index (Cdn. $)	+ 2.2%	- 5.2%	- 5.0%	- 3.5%
MSCI EAFE Index (Cdn $)	- 11.1%	- 10.0%	- 1.5%	- 4.5%

Portfolios that had a diversified North American exposure clearly benefitted as the spread in performance between the U.S. and Canadian markets in Canadian dollar terms was 13.3% in 2011.

Outlook for 2012

Making predictions for a new year is always a difficult task, but this year the uncertainty associated with emerging markets growth, upcoming elections in the U.S. Germany and France, and the European debt situation in particular, makes getting the outlook for this year a bit more difficult. With this in mind, here are some of my thoughts:

• By the end of the first half of 2012, the European debt crisis should begin to ease.
  
• Europe is likely to experience a mild recession in 2012.
  
• In 2012, the US economy will continue to muddle through - yet again!
  
• Despite slowing growth, China and India are expected to contribute more than half of the world's economic growth.
  
• US corporate earnings are expected to grow modestly, but won't likely exceed analyst's estimates as they have for the past three years.
  
• The interest rate spreads between Government and corporate bonds is expected to narrow - providing attractive returns for corporate bonds.
  
• US equities should experience a double-digit percentage return as price/earnings multiples are expected to rise modestly for the first time since the Great Recession.
  
• Dividends are expected to increase and share buybacks may be hit a record high.
  

Ongoing deleveraging and Government austerity programs should result in slow economic growth in 2012. Slow growth should be partially offset by the forces of accommodative monetary policy in much of the world, designed to provide the liquidity necessary for solvency and debt repayment. This combination of slow growth and debt repayment/deleveraging is likely to be a tricky one, fraught with occasional accidents and subject to low tolerance for policy errors.

A backdrop of slow, but positive, economic growth should allow for acceptable, but lackluster, earnings growth. Both "risky" and "safe" assets seem priced for such an environment. Whenever deflation is a risk factor for the global economy, equity valuations remain under pressure. Importantly, the US household sector has been steadily restructuring its balance sheet and lowering its debt service ratio. This positive step, combined with some increase in the pace of job creation, provides hope for a better year for equities.

The factors that could significantly improve the outlook would be one or more of the following:

• Europe moving toward resolution of its debt crisis,
  
• the United States heading toward fiscal responsibility,
  
• the emergence of a stronger US manufacturing sector,
  
• a stronger than forecast recovery in the US housing sector, and/or
  
• an increase in corporate and individual confidence.
  

• a systemic banking crisis in Europe,
  
• a true double dip recession in the United States,
  
• a hard landing in China, and/or
  
• a Middle East flare-up that drives the price of oil up by 50%.
  

My base case outlook avoids both extremes, but leaves much unresolved.

Should the "muddle-through" environment come to pass, I believe earnings and some improvement in confidence would allow equity markets to move higher, with US stocks leading the way. I believe there is a transition underway in the global economy from soft-landing to re-acceleration and this transition may be complete as early as late spring. The forecasted US employment growth will make the recovery more self-sustaining and may well help to contribute to a faster-than-expected decline in the US government deficit. I therefore continue to recommend an overweight in stocks, an "avoid" in exposure to Government bonds in favour of corporate bonds. Of course, one should still remain cognizant of the lingering risks associated with sovereign debt issues in Europe but there are definitely some positive developments in the economy and market.

There are a number of attractive investment opportunities at present and I would welcome your call to determine which are most suited to your objectives.