Allianz Global Investors is assuming that global growth over the coming year will remain slightly under trend, with growth in industrial countries, especially in the Eurozone and UK, likely to remain weak. Asia is projected to provide a modest tailwind but not at the levels generated in previous years. Japan, which looks likely to face recession again, is seen as an exception.

“The US, with its dynamic economy and more favorable demographic fundamentals, has a better platform than Europe for overcoming its debt situation.”

Given the disappointing recent economic data in combination with new monetary stimulus packages from the US Federal Reserve and the Bank of Japan, Andreas Utermann, co-head and Global Chief Investment Officer (CIO) at Allianz Global Investors, has acautious outlook for 2013: “The quantitative easing measures could be interpreted as a clear signal of difficult times ahead. And the US definitely has to face up to its fiscal challenges. Unless President Obama and Congress reach a new agreement, tax increases and spending cuts amounting to 4% of Gross Domestic Product (GDP) will take effect in the New Year. We believe that policy makers will, ultimately, pull back from the precipice in order to avert the negative consequences of the fiscal cliff on American growth in the coming year.”

Over the longer term, Utermann has fewer concerns about the US economy: “The US, with its dynamic economy and more favorable demographic fundamentals, has a better platform than Europe for overcoming its debt situation.”

Positive signals in the European Union but no sign of stability yet

Utermann identifies positive signals in the eurozone. In the middle of 2012, when sovereign spreads for peripheral EMU members hit record highs and yield curves for these countries flattened or even inverted, the market consensus appeared to be that the European Monetary Union (EMU) was not going to survive in its current form. In his opinion, the resolute and concerted actions of politicians together with the European Central Bank (ECB) have dealt with the risk for the time being, but have not yet solved it completely: “At the very least, the clear statement by Mario Draghi that the ECB would do ‘whatever it takes’ to save the euro has averted the ignition of a fire in Greece that would engulf the whole of Europe. This has changed the dynamic of the crisis in the eurozone insofar as politicians now have the space to regain the initiative.” He regards the European Stability Mechanism introduced in September as an important step forward, which is already being reflected positively in the capital markets. Overall, developments have confirmed his assessment that the crisis has promoted more intensive cooperative action within the eurozone rather than a break-up.

Nevertheless, Utermann maintains that this is too early to sound a general all-clear: “If the European Union is to be placed once more on a stable and credible foundation, three fundamental measures need to be implemented: the ECB must act as a lender of last resort for all countries. Steps also need to be taken in the direction of fiscal union. And thirdly, agreement needs to be reached on a banking union in order to remove the dependence that exists between government budget and the banking sector.”

Utermann considers that progress has already been made towards banking union in particular, with promising initiatives under discussion that include the ECB as a potential supervisory authority, which could be implemented as early as 2013. Nevertheless, during this difficult phase it can be assumed that the substantial parts of the population of the European peripheral countries will continue to react against the reform projects while the core countries decry the EU as a bottomless financial pit. Against the background of these highly charged sentiments, the Italian parliamentary elections in spring and the German election in the autumn of 2013 are risk factors that should not be underestimated.

Volatility stays at high levels in 2013

Despite an environment of low-to-negative real interest rates Utermann advises against focusing solely on continuous gains on stock markets: “Even though it might be tempting given some of the market gains this past year, only a long-term distribution of assets could cushion risks. Given the current economic conditions I believe it is risky to speculate on prices short-term.” Volatility will likely stay at high levels in 2013 because the markets continue to be driven by political events.

“Three years ago, we outlined for the first time that the path towards the new global equilibrium would be a long one against the background of massive government debts of the industrial nations and increasing savings rates in other parts of the world. This needs to be accompanied by a change in mindset on the part of investors: there will be no return to the old benchmarks for the time being,” says Utermann.

Even though the upside price potential for equities is limited in a generally fairly low growth environment, Utermann perceives good opportunities within the equity segment over the coming year. However, he emphasized that careful selection is more important than ever against a background of global challenges. There should be growth opportunities for companies with a robust international business model and a strong competitive position even in market conditions subject to difficult economic parameters. As he has done for the past two years, Utermann continues to underline his belief that investors should focus on dividend stocks. Over the past twelve months, the average dividend returns from healthy companies have already been significantly above the level of many standard fixed-income securities, a trend he assumes will continue.

Utermann also believes that, during the course of the upcoming year, defensive investment alternatives with the necessary potential for yield will include government bonds from selected emerging economies and their currencies, corporate bonds including high-interest bonds, and infrastructure investments*.

Outlook for the US

Given the uncertainty surrounding the fiscal cliff and the potential for very divergent economic outcomes depending on how it is resolved, the outlook for the coming year is cloudier than usual. US CIO Equities Scott Migliori at Allianz Global Investors, notes that the fiscal cliff, however, is not the only area of wide divergences in potential outcomes: “There is also a historically wide divergence between business and consumer confidence, with business confidence at low levels historically consistent with recession, while consumer confidence has been rising steadily buoyed by strong returns in equities and a rebound in home prices. Relatedly, capital goods orders have been dropping precipitously toward recessionary levels while payroll trends have diverged and, while certainly not robust, have not yet dropped coincident with capital goods orders as they have historically. We do not believe any of these divergences are sustainable for much longer, and their resolution will largely determine the prospects for growth in GDP and earnings and the direction of equity markets in 2013.”

Migliori remarks that the positive note of the continuing improvement in housing trends may signal heightened prospects for continued strong consumer spending and the eventual recovery of construction related employment activity. The most recent data shows median home prices rising over 11% year-over-year, and inventories continue to fall with months’ available supply now at the lowest levels since February 2006. The housing recovery is expected to continue and provide a tailwind to economic activity in 2013. However, it is worth noting that housing is not nearly as large a factor in US GDP as it was prior to the financial crisis, and there are historical examples where home prices have recovered while overall economic activity remain challenged (2001–2002 most recently).

Nonetheless, Migliori cautions on the improvement in housing trends: “The flipside to the robust housing story is the sorry state of business confidence and the related decline in capital goods orders. The key question is how much of this decline in confidence and orders is related to short-term concern surrounding the election and fiscal cliff, and how much is related to a more persistent downturn in the business cycle in the US? At this point, we believe it has more to do with the former than the latter, but we will need to see an uptick in first quarter capital goods orders to alleviate recessionary concerns.”

Investing in an environment with large divergences and a wide range of potential outcomes presents great challenges. Migliori advises “a “barbell” approach with overweights in areas that have good near-term earnings visibility (including housing/housing-related and select pharma/biotech stocks) while also building exposure in beaten down industrial and technology stocks tied to capital spending, as many of these stocks are trading close to trough valuations and thus provide a “call option” to any upturn in global economic activity.”

* Forecasts are not a reliable indicator of future results. This is no recommendation or solicitation to buy or sell any particular security.

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