Turmoil in Europe, prospect of “fiscal cliff” in US will keep investors on “rocky road” for rest of 2012, says iShares’ Russ Koesterich

Russ Koesterich, iShares Global Chief Investment Strategist, currently assigns a two-thirds probability to continuing global expansion, albeit at a below-trend pace, and a one-third probability to Europe provoking another global downturn.

In the second half of 2012 investors will face “a rocky road” compared with the year’s first few months, with the potential “fiscal cliff” in the US as well as Europe’s ongoing turmoil both posing risk to a still weak global recovery, according to Russ Koesterich, Global Chief Investment Strategist for BlackRock’s iShares business.

“At mid-year, the global economy is in roughly the same position as it was six months ago – an anaemic recovery threatened by a European crisis,” Koesterich said, in an update to his “iShares Market Perspectives 2012 Outlook” originally published in December. As he did in December, Koesterich currently assigns a two-thirds probability to continuing global expansion, albeit at a below-trend pace, and a one-third probability to Europe provoking another global downturn.

At the same time, he noted, “a number of risks have the potential to cause a global double-dip recession,” including Greece’s continuing problems, weakness in the Spanish banking system, and the potential hit of simultaneous tax hikes and spending cuts in the US at year-end.

In particular, Koesterich said, investors might be underestimating the possible impact of the US fiscal cliff. “Investor behavior suggests that the risk is not currently discounted into asset prices,” he said.

Europe remains the major risk, Koesterich noted. “While it appears, following the June 17 elections, that a Greek exit from the eurozone is not as imminent as some had feared back in May, the election results do not change the underlying fundamentals,” he said. “There is still a significant tail risk that Greece may eventually decide to exit the euro. Even if Greece remains in the euro, a bolder plan for tighter fiscal integration is proving frustratingly elusive.

“Due to Europe’s issues and the uncertainty surrounding US fiscal policy, we expect volatility to remain elevated,” he said. “We continue to advocate for a relatively conservative portfolio composed of high-dividend paying stocks and US ‘spread products,’ such as investment grade and municipal bonds.”

Mid-Year Outlook Charts Market Directions, Offers Investment Ideas

Koesterich’s mid-year outlook, “What’s in Store for the Second Half of 2012,” outlines the major factors likely to shape market directions for the next six months and provides a near-term outlook for key global regions and asset sectors, with details of related iShares investment products.

Absent a worsening of the crisis in Europe, economic growth in 2012’s second half should be broadly in line with the first quarter—positive but sub par – with US growth around 2% and global growth from 3% to 3.5%, Koesterich believes.

“The US is on marginally firmer footing and emerging market growth should begin to stabilise in the second half as the impact of 2011’s monetary tightening wanes,” he said.

Europe’s Risk Factors Stretch Beyond Greece

While investors enjoyed a temporary lull in Europe’s problems in early 2012, courtesy of the European Central Bank’s (ECB’s) massive injection of liquidity, the focus is once again on the Continent, Koesterich noted. Koesterich believes that the Greek banking system, Spanish banks, and political developments in Germany – Europe’s ultimate creditor – will be among the key factors shaping Europe’s fortunes as 2012 proceeds.

“If the Greek banks continue to bleed deposits, the ECB will need to provide more emergency assistance to prevent a collapse of the Greek banking system,“Koesterich said. “An even larger threat to Europe is Spain’s need to recapitalise its banking system, which is likely to cost at least €50 billion. To date, there is no credible plan.”

Germany also represents a critical swing factor for the European markets, Koesterich noted, because that nation is under increasing pressure to accept a plan for mutualising European debt. “Germany’s leadership has opposed such a move to date, but any development toward the pooling of at least some of Europe’s debt obligations would be a positive for the markets,” he said.

Uncertainty will yield continued stress in the financial system, Koesterich believes. “We don’t see another recession or a Greek exit as foregone conclusions,” he said. “But Europe is no closer to a political, economic or financial resolution to its problems.

“If Greece cannot abide by the terms of its austerity package, or if the Spanish banking bailout proves inadequate or unwieldy, then Europe’s chronic stress is likely to erupt into a crisis,” he said.

A Looming “Fiscal Drag” in the US

In the US, potential year-end tax hikes and spending cuts could create more than $600 billion in “fiscal drag,” or the equivalent of roughly 4% of GDP.

“Growth in the US is unlikely to be better than 2%, so if the fiscal drag were to occur, we believe a double-dip recession becomes much more likely,” he said. “A compromise that would avoid the fiscal drag is by no means assured, yet investors are placing a very low probability on the drag actually occurring, partly evidenced by the fact that 2013 growth forecasts have remained remarkably stable over the past nine months.”

Absent a clear consensus coming out of this year’s elections, November and December are likely to be marked by heightened volatility as investors grapple with the odds of a last-minute compromise, Koesterich believes.

With Markets “On Edge,” Where to Invest?

Markets are likely to remain “on edge” throughout the remainder of 2012, Koesterich said. “We prefer the relatively low beta of high dividend stocks—both in developed and emerging markets—and using any market weakness as an opportunity to add to longer-term positions in emerging markets.”

In addition to offering attractive yield, dividend stocks are generally less volatile than the broader market, Koesterich said. ”Since the correction began earlier this year, dividend-focused indices have generally outperformed the broader averages,” he noted.

Koesterich continues to advocate overweighting emerging markets. The continuing argument for the emerging markets rests on several factors including a longer-term trend toward less volatility, stronger economic growth, falling inflation and more compelling valuations, he noted. In late May, the MSCI Emerging Markets Index was trading for less than 11x earnings, the bottom quintile of its historical range.

In the fixed income space, Koesterich has favoured municipal bonds since late 2010. “Municipal yields are still at a significant premium to comparable Treasuries and there is little evidence of the feared meltdown in municipal finances,” he said.

He also continues to prefer US corporate bonds, particularly investment grades. “While high yield was the flavour of the month in the first quarter, we believe historically high spreads and less risk favour investment grade in the coming months,” he said.