Investment strategists typically draw a base case for the global markets and also an outside case -- low-probability events called "tail risks" that are more "what if?" than "what now?" situations.
But nowadays market volatility has grabbed investors by the tail, and risk-management is front and center. With uncertainty and unrest spreading from Athens to Manhattan's analysts at Bank of America Merrill Lynch thought it timely to assess some potential tail risks that could develop in 2012 and tell investors how to take advantage of them.
The base case for Merrill Lynch analysts is a relatively optimistic scenario. Here, the global economy slows but avoids recession, emerging markets post respectable growth, and China and the United States muddle through their economic troubles, said Kate Moore, a Merrill global strategist who contributed to the recent research report.
"The prevailing assumption is that companies are going to struggle and we're going to grind to a halt," she said.That's not how we view the world."
1. The Fed hikes interest rates
The idea that the U.S. economy would strengthen enough for the Federal Reserve to raise rates in 2012 strikes most observers as farfetched, if not ridiculous.
"It's a good thing to think outside the box, but that's in outer space," said Ed Yardeni, the president of market strategy firm Yardeni Research.
The Merrill strategists don't disagree -- in fact, their models indicate that the U.S. economy won't be strong enough to support a Fed rate hike until the third quarter of 2014. But that doesn't mean a rosy picture is out of the question.
"It's not a zero-probability event," Moore said. "The big surprise would be that the economy has bigger and stronger growth than we and the rest of the market expect."
Catalysts for U.S. economic growth would include election-year cooperation in Washington on spending and deficit reduction, and low mortgage rates spurring home sales and buoying the banking sector.
What to do
Whenever the Fed does hike rates, look for stocks to outperform bonds. Specifically, investors should then favor U.S. equities over emerging markets, and domestically focused small caps would trump globally oriented large caps, the Merrill report said. Municipal bonds do better than Treasurys, while corporate bonds and gold would come under pressure.
2. Social unrest rises
Seeds of social unrest are sprouting worldwide. In the United States, the fertilizer is double-digit unemployment, while income inequality between the wealthiest Americans and average citizens has hit a level not seen since just before the Great Depression.
Jeffrey Gundlach, the bond fund manager and CEO of investment firm DoubleLine Capital, offers this view of the Occupy Wall Street protests: The average American doesn't watch the stock market day to day, he said, but "they do know something is wrong when the library is closed on Thursdays, the potholes aren't getting fixed, big corporations are doing well and the CEOs look relaxed and tanned." So they are protesting "income polarization and policies that support it."
What to do
Social unrest is one tail risk that appears to be growing. The development doesn't bode well for most stocks, as it reflects deteriorating economic conditions, a stretched consumer, austerity in the absence of growth to repay debt and a lack of leadership and collective will to put people back to work.
The Merrill research noted that protests around the world create an environment that favors bonds over equities, and defensive stocks over cyclical stocks that would benefit from a clearer economic picture.
Treasurys are favored over corporate bonds, and in a more volatile world, safe-haven assets such as gold, and a play on food scarcity through agriculture and agribusiness shares would be warranted.
Source:(MSN)
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