World of possibilities

However, reports of the current situation rarely factor in that markets are ‘discounting mechanisms’ and therefore look to the future.

In other words, pessimistic expectations are already baked into valuations. From the highs of October 2007, European and UK equities fell 58 per cent and 45 per cent respectively peak to trough, thus ranking among the worst bear markets ever witnessed. The Great Depression of the 1930s generated a 66 per cent decline.

While many of 2011’s problems still exist, and provide a fragile environment for investing, 2012 starts on a different footing. The latest Bank of America Merrill Lynch fund manager survey reflects a practically ubiquitous preparation for the worst, with low expectations for “risk” asset market returns. There are reportedly large amounts of cash on the sidelines and sentiment measures are still near the equivalent panic lows of March 2009.

With many investors now firmly in the bearish camp, earnings and economic growth may surprise positively. It is at such times as these when dislocations of sentiment versus fundamentals allow for high returns on capital. This will be reflected in the better performance of most asset classes over the course of the next 12 months.

However, there remains many tail risks that leave this scenario vulnerable. The potential for a Chinese hard landing and a breakdown in Europe are also major factors running over into 2012. These will result in a continuation of 2011’s heightened levels of volatility.

Political factors

There is considerable political risk ahead of us, including US, French, Russian and Venezuelan presidential elections and political transition in China. The effect of geopolitical risk on markets is always hard to quantify.

The Arab Spring was a tame reminder for financial markets of the region’s potential. History paints a clear picture that regime change takes years not months to occur and it’s often an unpleasant and volatile process. Iran is a wild card and may become more so – the Straits of Hormuz could make more headlines than cared for over the year.

At the intersection of politics and finance, the eurozone crisis remains at the centre of investors’ concerns. It is unlikely there will be a distinct and definitive resolution, as there are deep-rooted structural issues that must be addressed and these cannot be resolved in the short term. The peripheral bond markets require time to demonstrate fiscal discipline without relegating growth to a distant memory, and this will also need investor confidence to return, on the back of a coordinated and well-resourced rescue effort.

If the threat of European contagion can be contained this would be very positive for sentiment and asset prices. It is evident that a meaningful recession in Europe is already factored into very cheap high yield and equity market valuations. However, the threat of deteriorating funding terms, and a major sovereign refinancing, hangs over markets in the first quarter of 2012.