Expect Continued Market Volatility and Modest Returns in 2012: BofA

(Newsroom America) -- Investors should expect another turbulent year of market volatility during 2012 from a mix of heightened policy risk, political uncertainty, low growth and low interest rates, all of which will translate into modest investment returns, according to BofA Merrill Lynch Global Research’s 2012 Year Ahead Outlook.

Against a backdrop of a looming recession in Europe, a still-struggling U.S. economy, high oil prices and slower growth in China, BofA Merrill Lynch Global Research’s macro analysts forecast global economic growth of approximately 3.5 percent during 2012. The team anticipates that credit and commodities will outperform equities in the first half of 2012 and recommends that investors overweight corporate and emerging market bonds.

“The global economy can weather a normal size recession in Europe, in our opinion,” said Ethan Harris, co-head of Global Economics Research. “The U.S. faces its own challenges, with gradual fiscal tightening and considerable uncertainty around policy after the election. As a result, while we expect solid 3 percent GDP growth in the current quarter, we look for growth to slow to just 1 percent by the end of 2012.”

Michael Hartnett, chief Global Equity Strategist and chairman of the BofA Merrill Lynch Research Investment Committee (RIC), added, “The very real risk of policy mistakes causing a recession in the U.S. or a hard landing in China means that investors should conservatively allocate assets in 2012. Despite our short-term caution, however, we anticipate that global equities could rally by 10 percent next year from current levels, aided by liquidity, modest earnings growth and cheap valuations. In a bullish scenario, 2012 could represent the beginning of the end of the great bear market in equities.”

“Emerging markets will de-couple from the U.S. and Europe, but the combination of lower growth in developed economies and moderately high commodity prices place emerging economies in a difficult position,” added Alberto Ades, co-head of Global Economics Research and head of GEMs Fixed Income Strategy. “The global growth malaise will mute export activity and temper demand for commodities, creating significant risks for emerging market investors in 2012.”

Ten macro themes for 2012

Heading into 2012, the RIC recommends investors position portfolios for the following ten macro themes:

* Slower economic growth. Co-heads of Global Economics Ethan Harris and Alberto Ades forecast that global GDP growth will slow modestly to 3.5 percent in 2012. The U.S. economy will enter 2012 with momentum but weaken in the second half to just 1 percent annualized growth in the fourth quarter of 2012. They expect Europe will see a mild recession, while emerging market economies will see growth of 5-6 percent. Asia should remain the most resilient with growth of 7.1 percent and Latin America should see growth of 3.3 percent. * The U.S. consumer will weaken…again. The U.S. Economics group expects the recent momentum from U.S. consumer spending to subside in coming quarters, absent much stronger jobs creation or wage growth. Consumer de-leveraging will remain a drag on the U.S. economy in 2012. * A soft landing in China. China is vulnerable to a U.S. and European recession, but a healthy balance sheet, slowing inflation and massive foreign reserves mean China can ease aggressively, if necessary. The Global Economics team expects China to avert a hard landing and forecasts GDP growth of 8-9 percent in 2012. As inflation risks fade in 2012, the group looks for Chinese policies to turn increasingly pro-growth. * Quantitative easing in the U.S. and Europe. Tighter fiscal policies in the U.S., Europe and Japan are likely to be offset by accommodative monetary policies around the world, aided by lower inflation. Importantly, the Global Economics team projects fresh rounds of quantitative easing by mid-2012 in both the U.S. and Europe. The RIC expects that this will prove to be an important inflection point for risk assets and could support commodity prices in the second half of 2012. * U.S. Treasuries to remain the safe-haven asset of choice. Head of U.S. Rates Strategy Research Priya Misra expects the Fed to communicate a much longer on-hold policy. She expects 10-year Treasury yields to fall to 1.6 percent early in the year due to risks from Europe, triggering policy response which should help rates increase to 2.4 percent by year end. While Treasuries are likely to remain a safe-haven asset, the downside and upside on yields are expected to be limited. * Yield and income will remain paramount. The year 2012 will likely be another environment of low rates and scarce yield, and investors will continue to seek assets that provide attractive yields. U.S. Credit Strategist Hans Mikkelsen is bullish on corporate credit and expects credit spreads to tighten significantly by the end of 2012. The credit strategy team forecasts total returns of 4.8 percent and 13.9 percent from U.S. investment-grade and high-yield bonds, respectively. * Modest upside for equities. Equities should offer roughly 10 percent upside in 2012. Deleveraging and slower earnings growth are expected to limit the upside, while quantitative easing, valuation and positioning limit the downside. The Global Equities team recommends focusing on sectors that provide high growth, high quality and high yields. The equity strategy teams’ 2012 year-end targets are 330 for MSCI All Country World Index and 1,350 for the S&P 500. * Large-cap equities will outperform small-cap equities. Head of U.S. Small-Cap Strategy Steven DeSanctis expects large caps to continue to outperform small caps in 2012 as earnings growth and valuations are better for larger companies. Heightened volatility and macro uncertainty offset the clean balance sheets and potential for M&A within small caps. * Stock picking opportunities likely to emerge. Correlation and volatility are likely to decline in 2012, once a macro solution for Europe’s debt problems is implemented. This environment favors active fund management in the year ahead. * Emerging market interest rate cuts support risk assets and commodities. Despite risks, the Global Economics team expects emerging markets to continue to be the engine of global growth in 2012. Emerging market government debt-to-GDP ratios are well below those in developed markets, leaving room for increased public spending. And as recent monetary policy easing in Brazil, Russia and Indonesia suggest, emerging market central banks are likely to be pre-emptive in supporting growth.

Top U.S. market ideas for 2012

While the U.S. economy has achieved some momentum going into 2012, BofA Merrill Lynch Global Research recommends that investors approach the U.S. markets tactically and with caution next year.

Savita Subramanian, head of U.S. Equity and Quant Strategy, forecasts the S&P 500 will end 2012 near the highs of its two-year trading range, with a year-end target of 1350. “Asset correlations and volatility could remain high next year, while U.S. corporate profit growth will decelerate,” said Subramanian. “To navigate this market, investors should focus on stocks and sectors that have differentiated performance, and on secular, rather than cyclical, growth opportunities. Companies that deploy cash through dividends and buybacks rewarded investors in 2011, and that trend will continue in 2012.”

Priya Misra, head of U.S. Rates Strategy Research, commented, “Policy uncertainty, slower economic growth and risks from Europe will drive price action in the U.S. rates market in 2012. We expect the situation in Europe to get worse before it gets better, and therefore look for the Fed to keep rates low well into 2014, creating opportunities for investors in the belly (five to seven years) of the U.S. Treasury curve.”

Below are five specific tactical ideas to navigate the U.S. markets in 2012:

* Corporate bonds issued by large U.S. banks and high yield companies: Despite slow economic growth and low rates, large U.S. banks are expected to continue to benefit improving credit fundamentals, wide spreads and systemic support. U.S. high-yield companies are attractively priced as spreads more than adequately compensate for adverse economic risks. * High-quality, high-yielding municipal bonds and “kicker bonds”: Tighter U.S. fiscal policies on the federal, state and local government levels will be positive for bonds of high-quality municipal issuers. Within high yield, head of Municipal Research John Hallacy favors AA-rated hospital system bonds ,Airport General Aviation revenue bonds and Dedicated Sales Tax or other special tax Transportation bonds, as well as “kicker bonds” (high coupon bonds with short calls). * Quality, Growth and Yield should benefit. According to Subramanian, high volatility and slowing earnings growth both suggest that quality and growth will continue to outperform. She recommends U.S. equity overweights in consumer staples and technology and underweights in materials and financials. * U.S. technology companies: U.S. technology companies have the highest cash levels of any sector in the S&P 500 and are more likely to grow dividends, buy back stock and increase capital expenditures. Additionally, companies in this sector have high earnings stability and attractive valuations – over 80 percent are trading below their five-year average price-to-earnings valuations. Internet Software & Services and Computers have the strongest secular growth prospects. * Watch the technicals: As long as asset prices remain in trading ranges, technical analysis will be relevant, said Mary Ann Bartels, head of U.S. Technical and Market Analysis. “The best entry point into U.S. equities is at the 1,074 – 1,100 level on the S&P 500 index, and profits can be taken on the S&P 500 in the 1,300 – 1,350 range,” she said.