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A year in two halves.

With the first being economically more challenging than the second. And this should have an ultimate bearing on what the stock markets do.

Happy New Year

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What will we see this year?

We see the year ahead in two halves, with the first being economically more challenging than the second. And this should have an ultimate bearing on what the stock markets do. However, given the fact that stock markets have a history of anticipating future economic and market expectations by around six to nine months, could the first few months of 2012 be positive for stock prices?

That accepted, there are three issues that equity markets will have to deal with:

The first is Europe. What the EU member countries and the related regulators decide to do is bound to have a big bearing on stock prices. The recent history of decisions from the Continent doesn't do much to raise optimism for share prices in 2012. But we do think we've seen steps in the right direction that will emerge as more stable strides in the first part of the year.

The EU leaders announced two major initiatives to help stabilise EU sovereign debt markets; a new 'fiscal compact' and measures to enhance the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM). The 'fiscal compact' aims to strengthen the fiscal and governance regime surrounding the euro area and imposes a new fiscal rule on Member States. As a result it is expected that general government budgets shall be balanced or in surplus - this is when the annual structural deficit does not exceed 0.5% of nominal GDP - otherwise automatic sanctions will be imposed. No specific details are available as yet.

The permanent bailout fund, the ESM will be brought forward to July 2012 and, together with the EFSF, will have a combined limit of €500bn.  The aim is that a further €50bn will be contributed by non-EU member states. While these measures are a further step in the right direction there is not, as yet, a comprehensive solution to the debt and economic problems in Europe.

Of course, if the Europeans show credibility with their decisions in the early part of 2012, linked to Europe's policies on debt management, resulting in a high trading range for markets.  All that said, European decision makers have been slow to make the necessary policy decisions and that's why we've argued that the first half of the year will be more challenging than the second.

Slowing in China

Slower-than-expected China, which we don't think will be as bad as some doomsday merchants would have it, but it won't be helped by Europe, which will be in recession. In China, monetary policy was eased through a lowering of the reserve requirement ratio for banks from 21.5% to 20.0%. This was the first easing since October 2008. It is expected any easing in policy in 2012 from China will be gradual with the policy focus based on the Central Economic Work Conference to be "proactive fiscal and prudent monetary policies", indicating "growth stabilisation" policies rather than control over inflation. Inflation in China has continued to ease, with the annual rate falling to 4.2%/yr in November, down from 5.5%/yr the previous month and a peak of 6.4%/yr in June. This should enable a gradual easing of policy during 2012.

According to the latest Associated Press survey of 30 economists, the USA should grow by around 2.4 per cent, which isn't bad and should support stock prices. However, even this is likely to unfold in two halves as well, with the second part of the year showing stronger share price growth compared to the first. Inflation in the US appears to have peaked, with headline CPI slowing to 3.4%/yr in November, down from a peak of 3.9%/yr in September. This is helping to increase purchasing power among consumers.

The survey of economists in December got it right when it concluded: "Beyond Europe, troubles in other areas could also upset the US economy next year. Congressional gridlock ahead of the 2012 elections and unforeseen global events, like this year's Arab Spring protests, could slow the U.S. economy. Three economists said rising nuclear tensions with Iran are a concern." (Detroit Free Press)

On the home front

The Australian stock market is overdue for a comeback, even though we've seen a disappointing calendar year for stocks (-10.5%), on a financial year basis we've seen two positive years in a row. We expect we'll see another by June 30.

Interest rates on the slide

Locally, we expect interest rates to fall at least once more but suspect we'll need two cuts to turn around both consumer and business confidence. If this happens, we'll see our economy get stronger over the course of 2012, though the introduction of the carbon tax will be a big test.  The tax cuts will run ahead of the new tax and this may have the double-barreled effect of helping the economy grow, as well as offsetting the dread linked to the carbon slug on our hip pockets. In spite of two recent interest rate reductions by the Reserve Bank of Australia (RBA), conditions remain challenging for discretionary retailers. This is due to relatively low consumer confidence levels - the savings rate has recently increased and is now above 10% - and the increasing number of people shopping online, often from overseas websites where goods are typically cheaper than those available in Australian stores.

Your portfolio

Stock markets won't be down and struggling forever. We think the second half of 2012 will be the start of something bigger and better, the slow but steady recovery!

"You always have two choices: your commitment versus your fear."
Sammy Davis, Jr.