As turbulent fourth quarter comes to a close, will sunnier skies prevail for investors in 2012?

As the fourth quarter comes to a close, it’s clear that Europe’s sluggish economy will continue to adversely impact the United States; the only question is by how much. We believe that Europe will also likely dominate the U.S. economic storyline into 2012 as well, as the continent could stunt growth in China, which is a major European trading partner. These conditions increase the likelihood of large market swings in 2012, so investors need to closely monitor their portfolios and gauge their tolerance for market volatility.

Fourth quarter volatility
As the fourth quarter comes to a close, the U.S. economy continues to face a turbulent climate. In U.S. equity markets have been marked by high volatility, a storyline that unfolded throughout the year, with the benchmark indices ending the year close to where they started. Compared to the market declines in Europe and emerging markets, U.S. performance has been robust.

In bond markets, U.S. Treasuries continued to be a port in the storm, as the global market uncertainty triggered a flight to quality. Yields were lower than anyone expected, and spreads on corporate bonds and emerging market bonds tightened.

The U.S. economy showed renewed signs of strength in the fourth quarter, with growth at about 3%, but signs of weakness persisted. Unemployment was stubbornly high – even with the December 2 announcement that the jobless rate had fallen from 9% to 8.6%. The large drop reflected some encouraging news – 120,000 people reported entering the workforce. However, half of the decline in the unemployment rate was a function of people dropping out of the workforce, which means they are no longer counted as “unemployed.”

Europe’s forecast for 2012
Looking ahead to 2012, the biggest question mark for the U.S. economy is Europe. As European policymakers try to resolve the debt crisis, they face a toxic mix of slow growth, high unemployment and large budget deficits. To rein in the deficits, a number of countries are pursuing austerity measures – higher taxes and lower spending. But these measures will create their own set of challenges, as they will also reduce GDP, which will reduce tax receipts – a vicious cycle that further complicates the ability of countries to pay off their loans.

The challenges also exist at the pan-European level, as the European Union is wrestling with how much authority to grant to Brussels regarding individual countries’ fiscal and monetary policies. This will be a highly contentious debate, given the difficulty of securing agreement among all of the EU’s 27 members (or even just the 17 in the eurozone).

With the turbulence in Europe driving down consumer spending, we expect the continent to buy fewer products from China. That may lead Beijing to pursue stimulus measures, as it did with a $586 billion stimulus package announced during the global financial crisis. Such measures would help China maintain an annual economic growth rate of 9%-10% even in the face of depressed demand from Europe.

We believe that the biggest danger for the U.S. economy – and the global economy – is a breakup of the eurozone and the elimination of the euro as a cross-border currency. That would spark massive transition costs as countries switch back to national currencies, and it would trigger long-term uncertainty that would depress economic output. But even if the eurozone stays together, the economic slowdown will impact the U.S. economy, given that the region is a huge market for U.S. goods and services.

Besides fallout from the eurozone, the biggest drag on the U.S. economy into 2012 will continue to be the residential housing market. With close to one in three mortgages underwater, people have less money to spend and that depresses consumer demand across the economy. The mortgage situation also translates to lower-than-usual housing starts and also fewer sales. The weakness of the economy is, in part, a byproduct of the failure to enact any comprehensive policies to re-energize the housing market, akin to the Troubled Asset Relief Program for banks.

U.S. unemployment will come down a bit more in 2012, but we believe that it will still remain above 8%. With so much slack in the economy, inflation won’t be a concern, declining to 3%.

Market outlook
Market performance in 2012 will be driven by the ongoing challenge for U.S. companies to increase revenues. We don’t see signs of a major stock rally nor decline. The challenge will be particularly acute for large-cap companies, which tend to have major trading partners in Europe and Asia. Small- and medium-cap companies will likely fare better, since they tend to be more geared toward selling to the U.S. market.

On the fixed-income front, we expect U.S. Treasuries to remain stable, unless there’s extreme turbulence in Europe (such as a breakup of the eurozone), in which case risk-averse investors would flock to the stability offered by U.S. debt. If the U.S. economy continues to improve, corporate bonds will be more attractive, as credit spreads with U.S. Treasuries will tighten.

Corporate earnings (S&P 500 companies) will remain strong in the fourth quarter, and absent a collapse in the eurozone, we expect 2012 earnings growth to be roughly even with 2011. Sectors likely to be strong performers include consumer staples, consumer durables, natural resources and health care. Commercial real estate is also likely to perform reasonably well, because it didn’t experience the residential real estate bubble, while emerging markets could be attractive given the depressed prices.

One of the wild cards for 2012 is what Washington will do, if anything, about the federal budget deficit. While the largest savings can be realized through reforms to the Medicare and Medicaid programs, the political sensitivities associated with those programs makes any reforms unlikely – particularly in an election year.

Market performance in presidential election years
Historically minded market watchers may find it noteworthy that in presidential election years going back to 1928, the S&P 500 has nearly always shown a positive return. But the three times it didn’t were in 1940, 2000 and 2008 (when the S&P index was down 37% that year). So while the long-term trend of market returns in presidential years is positive, current conditions don't presage a big market increase.

For investors, we believe the uncertain political and economic climate reinforces the importance of a well-diversified portfolio. And while there may be considerable volatility ahead, investors should remember the experience of 2008-09. While there was a steep market plunge, from the bottom of the market on March 9, 2009, through the end of the year, the Dow rose 60%. That’s a reminder that volatility can be an investor’s friend.

Positioning one’s portfolio to minimize the pain from market downturns, and benefitting from market upswings, will certainly remain a careful balancing act in 2012.