Andreas Utermann, Global Chief Investment Officer at Allianz Global Investors/RCM, provides his outlook for 2012:

“As we head into 2012, I will focus on the themes likely to shape the direction of capital markets and provide a brief outlook for each major asset class. In doing so, I shall highlight our predictions from last year1 and consider in the light of how actual events played out.”

Economic outlook

Our predictions for 2011: Trend economic growth will probably remain lower than before the crisis; however, given the low level of central bank rates, high cash positions of the corporate sector and solid demand from emerging markets, economic growth should be reasonable.

“While 2011 growth was indeed solid, we are clearly facing a significant slowdown in economic activity in 2012. The rise in oil prices in the first of half of 2011, tighter monetary policy in emerging markets, and, of course, fiscal tightening in the US and in Europe, are all taking its toll on growth. Since the summer, tensions in the financial markets have added further pressure: with financing conditions for banks becoming more difficult, we expect this to have a negative impact on credit growth going forward. Already, lending surveys are pointing to a headwind for the credit cycle.

“Still, we don’t expect most developed economies to fall into recession as real interest rates remain ultra-low and also because the private sector is in a position to spend out of cash-flow. We are also expecting emerging market growth to remain solid supported by increasing domestic demand.

“However, growth risks are clearly increasing. This is particularly true for Europe, where fiscal tightening is most pronounced. This could be exacerbated if the stressed financial system, notably the banks, continues to see balance sheet contraction in response to the crisis, which would further reduce credit availability to the private sector at a time when it is needed most. A recession is becoming increasingly likely.

“Our medium term outlook remains unchanged: in times of high public sector debts, and private and public sector deleveraging, trend growth may be lower than before the burst of the bubble. This period is likely to last for several years.”

Budget deficits

Our prediction for 2011: While major sovereign defaults have been averted, the spectre of debt restructuring or even default for some of the Euro-zone’s peripheral countries would continue to haunt the markets.

“While our expectations for on-going debt problems in the Eurozone have turned out to be correct, we did not and could not have anticipated the kind of escalation of the debt crisis which we have witnessed since the summer.

“Given the complexity of the problems, a quick fix is unlikely. Political actions which can realistically be implemented—i.e., fiscal tightening, tighter harmonization of economic and fiscal policy in Europe—take a long time to be implemented and even longer to be effective; in our view most likely too long for financial markets. The longer the debt crisis looms, the bigger the political risk. As the recent developments in Greece show, there is a real threat of a break-up of the Eurozone, if political processes get out of control.

“While debt monetization is already on the agenda in the US and UK, this process is not yet on the agenda in European Monetary Union (EMU), even though the European Central Bank (ECB) has become more ‘Fed2–like’ recently. Medium-term, though, we think that a more active and aggressive role for the ECB is a likely outcome. This necessitates decisions by policy makers to build a much more fiscally and politically integrated Eurozone including sanctions for countries with unsound fiscal policies.”

Inflation

Our prediction for 2011: We would see diverging inflation trends, with continued moderate inflation within the central banks’ comfort zone in the more highly indebted countries, and higher inflation in the countries with trend or above trend growth.

“Indeed, inflation rates have risen in emerging markets, in some cases 10% or more3. Central banks have reacted accordingly and embarked on a tightening cycle. In the second half of 2011, rates peaked but even now remain at comparatively high levels3. In the developed world, inflation rates are clearly below the levels witnessed in emerging markets. However, they have also risen to new cyclical highs and are now above the levels which central banks are aiming for in the medium term3.

“In our view the rise in the oil price at the beginning of the year is not the only explanation for a pick-up in commodity prices. Core inflation has started to increase as well in developed markets; in emerging markets, wage pressure has added to price increases.

“We think that the cyclical moderation will trigger a moderation in inflation rates again. Given the low level of real interest rates, on-going central bank balance sheet expansion, and our expectations of continued solid growth in Asia, we do not expect a return of deflationary fears, despite weakening growth. On the other hand, with demand for money being strong in the current period of deleveraging, nor is inflation likely to be a threat in the foreseeable future.”

Interest Rates and Bonds

Our predictions for 2011: We anticipate little movement in short rates for the major OECD economies but gradual tightening in the emerging markets. We would be very cautious towards medium to long-term maturities across the world, which we feel are significantly overvalued owing to quantitative easing (QE) activity and undue risk aversion.

“The ECB hiked interest rates twice in 2011 but has now started to back-pedal and cut rates again. US and UK interest rates have remained extremely low, while in emerging markets, the on-going cycle of rate hikes has come to an end and in fact several emerging economies have recently started to cut rates.

“Looking ahead we expect rates to start to come down further in the Eurozone whilst emerging markets are likely to continue to reduce rates. In the US and UK, as well as in Japan, we expect the policy of extremely low interest rates to continue into the foreseeable future.

“While our expectations for the short end of the yield curve turned out to be reasonably correct, the long end of the yield curve has behaved differently. In the US and UK, on-going sovereign bond purchases by the central banks in addition to weaker economic data since the spring have brought bond yields down. As we do not anticipate a major reversal in the economic news flow, and as the Fed and the Bank of England may continue to buy bonds again on a large scale, the downside to bond prices in both markets is clearly limited. Bond returns in both markets are likely to be at around the current redemption yield.

“In Europe, bond markets are very much driven by political developments. Admittedly, bonds in the EMU periphery very much discount potential losses. However, as long as the political uncertainty persists and economic data remains weak, we expect risk aversion to prevail. German government bunds are likely to remain safe haven assets for the time being.

“A ‘risk-on’ trade within the European bond markets is only likely to start once economic data starts to improve or the ECB takes a more active role in solving the debt crisis.

“Longer-term, we remain cautious on sovereign bonds at current yields. Even if nominal returns may turn out to be positive, we expect real returns - i.e. inflation adjusted - to be disappointing.”

Equities

Our predictions for 2011: Political tensions or sovereign debt fears would be another buying opportunity for those who want to establish longer-term positions. Note that these preferences could reverse following a bout of risk aversion, during which emerging market equities would probably underperform.

“After a strong performance in the first half of 2011, equity prices have fallen significantly from their calendar-year highs and are now slightly below the levels seen at the beginning of the year in the US; are in Europe, down around 20; and in Japan, down 17%. Emerging markets, too, have fallen in absolute terms. Some of the headwinds which explain the reversal in stock prices in the course of 2011 are likely to stay with us in the coming months and could continue to weigh on equities next year. In particular, the EMU debt crisis remains unsolved, even though the most recent decisions are a step in the right direction. Still, markets are likely to continue to price-in the continuation of the debt crisis for longer. This, per se, also increases the risk of policy failures or electorates may start to question the concept of a European currency union altogether. The most recent developments in Greece and Italy show that this risk is not abstract but very real.

“Against this backdrop, and with economic activity slowing down globally and moderate equity returns, we prefer stocks with relatively high dividends and pay-out ratios. Dividend payments should offer investors some protection in the current environment.

“A lasting rebound in equity markets is expected to take place only if markets can start to price in a credible solution to the EMU debt crisis and/ or when economic data are pointing towards a stabilisation in economic activity.”

Currencies

Our prediction for 2011: The US dollar currently could rally somewhat against the euro. Longer term, we continue to expect emerging market currencies to appreciate against the US dollar and somewhat less against the euro.

“The US dollar has range-traded against the euro this year. Going forward, we expect some appreciation of the US dollar because of the still-unsolved Eurozone debt crisis. In addition, the US dollar looks somewhat undervalued relative to the euro.

“Emerging markets turned out to be weaker this year than we originally expected. With the exception of the Chinese renminbi, which has continued to show solid and steady appreciation against developed market currencies, the picture for other emerging markets is rather mixed. The real and the rupee in particular depreciated against the US dollar, explained by both risk aversion and relatively high valuations.

“Strategically, we hold on to our expectation of appreciating emerging market currencies due to superior growth (and productivity gains). We are waiting for an attractive entry point to re-enter this trade.”

Emerging Markets

Our prediction for 2011: the strategic importance of emerging markets has been confirmed and 2011 will seemingly see a continuation of this theme. Good-bye G7 and hello G20.4

“Emerging markets are likely to remain strategically important and the slowdown in economic activity will end, in our opinion, in a soft rather than a hard landing. The reasons for our relative optimism are the negative real interest rates, the rather low level of total indebtedness, as well as strong underlying demand. Our positive view on emerging markets leads us to a strategically positive view on emerging markets assets, be they equities, bonds, or currencies, valuations notwithstanding.”

1 Allianz Global Investors press release dated 30 November 2011.

2 US Federal Reserve

3 Source: Allianz Global Investors/RCM.

4 The Group of Seven or ‘G7’ is the meeting of the leaders of the major industrial nations of the world namely Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. The ‘G20’ includes additionally Argentina, Australia, Brazil, China, European Union, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, Republic of Korea and Turkey.

About Allianz Global Investors

Allianz Global Investors, the asset management subsidiary of Allianz SE, has circa €1.5 trillion in assets under management for its clients worldwide (as of 30 June 2011). Its investment managers offer their own distinctive investment philosophy, and provide clients with a comprehensive and constantly evolving range of products and services. Its 4,900 employees around the globe, including more than 1,000 investment professionals, are committed to helping clients achieve their goals by combining global expertise and local market knowledge with innovative solutions and world-class professional service.

About RCM

RCM is a global asset management company providing active investment strategies. The firm operates from six offices—Frankfurt, Hong Kong, London, San Francisco, Sydney and Tokyo—with assets under management of over US$128 billion worldwide. At RCM, we believe that by generating and exploiting an information advantage, we will be able to deliver superior and consistent investment results for the benefit of our clients—a philosophy we call RCM informed. RCM is a company of Allianz Global Investors, a preeminent global asset management group committed to helping clients achieve sustainable success. As a company of Allianz Global Investors, RCM offers a distinctive investment philosophy and culture, while benefiting from the scale and substantial resources of our parent, including business support, industry best practices and financial investment.

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(All data sources RCM as of 30 September 2011 unless otherwise stated.)