2012 Market outlook | By Pax World Chief Investment Officer, Chris Brown

Looking back on 2011, several political, economic and environmental events had significant impacts on global markets. The March tsunami in Japan and the resulting nuclear disaster at the Fukushima Daiichi nuclear power plant and flooding in Thailand all took their toll on the global economy. In particular, component shortages impacted the automotive, industrial and technology industries. Unfortunately, environmental disasters are becoming more commonplace and are having a greater impact on the global economy. In our opinion this validates our belief that environmental events and their impact on the economy should be incorporated into a sustainable investment process. On the political and economic fronts, gridlock in Washington and the sovereign debt crisis in Europe significantly impacted markets, with investors’ uncertainty triggering frequent bouts of volatility. Despite a downgrade of U.S. government debt by Standard and Poor’s in August, the Treasury market rallied, with no immediate impact on the financing needs of the U.S. government. However, the longer-term implications are yet to be known and are certainly signaling a message with regard to our own budget deficit. In general, the U.S. economy showed signs of recovery throughout the year, albeit at a slow and bumpy pace.

Despite the many major global events impacting markets in 2011, the S&P 500 Index¹ ended positive, gaining 2.11%, and the Dow Jones Industrial Average² rose 8.38%. International markets didn’t fare as well, with the MSCI EAFE (Net) Index³ losing 12.14% for the year.

I believe that Europe will continue to be at the forefront of events that will shape the global economic environment in 2012. International markets continue to struggle as they manage the fallout from the debt crisis and related austerity issues. Stock valuations in some parts of Europe look compelling. In particular, Germany continues to show resilience with respect to industrial production and exports. The emerging markets were not immune to the sovereign debt crisis, as many of their indices declined dramatically. However, I believe emerging markets will be one of the bright spots for investors as countries continue to build their economies and spend on infrastructure. At this point, there is no clear picture as to how Europe will solve its debt crisis and whether the European Union will remain fully intact.

The U.S. economy appears to be picking up some steam. Recent housing and unemployment reports indicate signs of a recovery, and the majority of leading economic indicators made positive contributions in November. Consumer sentiment also appears to be on the rise. Unemployment and housing are the critical components for a U.S. recovery. I anticipate that unemployment will slowly trend downward and job creation should continue at a tepid pace. However, the “boomer” generation’s exit from the workforce may begin to become a significant catalyst for an improving employment rate. An improving employment environment could allow consumer sentiment to continue to rise, and non-distressed home prices should, in our opinion, stabilize.

Against this back drop, I expect moderate gross domestic product (GDP) growth for the U.S. and possibly a mild recession for Europe during the first half of 2012. Weakness in Chinese markets could also inhibit global GDP growth. I think global equity markets should continue to produce the volatility levels to which we have become accustomed, along with a high correlation for most markets. It’s difficult to predict exactly where markets will take investors in 2012, but I am cautiously optimistic that the S&P 500 Index will close at around 1400, gaining approximately 10%, by year end. This is a very difficult call to make given the level of global uncertainty, but I do believe that U.S. companies in general will post decent earnings growth for 2012.

As I write this outlook, Washington finally approved a two month extension for the payroll tax cuts. It took considerable wrangling and debate to pass the bill, which only covers a short period of time. Unfortunately, this type of “gridlock” will most likely persist as each party jockeys for position preceding the 2012 elections. I anticipate that this will continue to contribute to market volatility this year.

From a sector perspective, energy, industrials and technology look promising in 2012, in our view. While elevated, the price of oil does not appear to be reducing demand and is high enough to incentivize companies to increase their exploration budgets. However, the price of natural gas remains under pressure as supply has overwhelmed demand. Longer-term, I anticipate more companies and the general population to switch to natural gas due to its inexpensive price relative to oil. I believe it is a bridge fuel and one of the major natural resources the United States can utilize to lessen its dependence on foreign oil. There are clearly many environmental issues to contend with and development needs to proceed in a responsible manner. I also believe infrastructure spending on energy distribution will have to increase dramatically to allow movement of liquids from sources to intended markets.
 
Industrial companies in general continue to demonstrate resilience in demand for their products. Overall, commodity prices appear to be softening, which I believe will bode well for industrial companies. Low commodity prices should reduce input costs, allowing some relief and expansion of their margins. Dividend yields also look attractive for many of the industrial companies we hold.

Technology has faced some headwinds due to a decrease in government and financial service company spending. However, internet mobility, cloud computing and strong demand from emerging markets may help offset the reduction in spending. I am focusing on technology companies that will provide solutions and more efficiency for their customers regardless of the economic environment.

As always, Pax World has carefully positioned the Funds as we head into 2012. In addition to focusing on companies with sustainable business models, we have been increasing the Funds’  emphasis on income. In light of the current economic environment, we believe income will be a primary driver of total returns. Dividend yields are generally at very attractive levels and corporate balance sheets continue to remain strong. We anticipate companies with large amounts of cash on hand and strong cash flows to reward shareholders with higher dividends in 2012.

¹The S&P 500 is the Standard & Poor’s composite index of 500 stocks, a widely recognized, unmanaged index of common stock prices. One cannot invest directly in an index.

²The Dow Jones Industrials Average is a price-weighted average of 30 actively traded Blue-Chip Stocks.

³The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. As of July 2010 the MSCI EAFE Index consisted of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. One cannot invest directly in an index.

Past performance does not guarantee future results.

The statements and opinions expressed are those of the author as of the date of this report. All information is historical and not indicative of future results and subject to change. This information is not a recommendation to buy or sell any security. Past performance does not guarantee future results.

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