THE investment outlook in 2012 depends very largely upon Europe. If the euro fragments, there would almost certainly be a depression in Europe and recession in the wider world. If a practical way forward is agreed that convinces bond investors that they can safely lend to European governments in euros, there is the potential for a sharp rise in the price of risk assets, which would be driven partly by the deployment of investment funds currently frozen by uncertainty.

The plan outlined by the EU Summit last week ticks some important boxes. It proposes innovative routes to increase capital buffers (using the International Monetary Fund) and commits to apply penalties for fiscal misbehaviour in a new intergovernmental agreement between most of the members of the EU. However, details are conspicuous by their absence, including an understanding of the European Central Bank’s (ECB’s) role as lender of last resort.

The net result is that, although steps forward have been taken, we are still some way from diffusing the tension currently paralysing the European banking sector and investors. Chancellor Merkel has recently done a good job in emphasising that there is no magic solution (the ECB buying everyone out of their difficulties), signalling that stabilisation will take time.

Looking at the situation through German eyes, it is logical to retain the “big stick” of an implied threat to leave an intransigent debtor nation to the mercy of the markets while they have yet to fully implement a more sustainable budgetary direction.

For us as investors, however, we must recognise that a decision has been taken that it is worth paying the price for a structural re-engineering of the euro after a Teutonic model, namely a prolonged recession caused by fiscal austerity compounded by accelerated deleveraging of the European banking system.

As a result, we must face the fact that Europe will be a greater drag on global growth in 2012 than had previously been expected. Although the US and emerging markets may partly compensate, this is by no means certain – making for a challenging outlook for global corporate earnings.

Adding to the uncertainty is the huge changing of the political guard scheduled for 2012. Elections or leadership transitions will occur in USA, China, Russia, France, Italy, Germany and Taiwan, to name only some of the more important areas. Furthermore, the situation in the Middle East is far from stable (Iran and Syria) and surprises from there are unlikely to be positive – any spike in energy prices would add to burdens.

The combination of factors will make for another year of living dangerously. However, one must also recognise that the problems are well appreciated by investors. There is little “naive” money taking inappropriate risks, little pressure on profitable corporations to cut back sharply, and valuations are not at levels that are consistent with the start of prolonged (or profound) bear markets. Indeed, should Europe continue to take steps in the right direction, it may quickly be perceived that the Sword of Damocles has been lowered, even if not fully sheathed, providing room for considerable relief. Our best guess for stocks and shares is for a broadly flat but turbulent first half, followed by a more settled second half to the year – but there are few greater fools than market forecasters!

John Haynes,

Head of Research,

Investec