Sceptics would suggest that the solid start to 2012 is little more than a typical “January effect” in which stocks tend to rise at the beginning of the year, but we think there is more to it than that. In part, we believe the upward moves of the last few weeks can be attributed to the fact that many investors (including active fund managers) came into the year underexposed to risk assets, following a disappointing 2011, and are at this point starting to put their cash to work.

 

So, what will it take for the market’s winning ways to continue in the year ahead? We are cautiously optimistic that good returns for stocks will not require strong economic or earnings growth this year, nor will they require significant upside surprises. In our view, given that expectations and investor sentiment are quite depressed, if the world is able to avoid major accidents and policy mistakes and if existing sources of risk are contained, we should see some decline in volatility levels and a diminishing of investor uncertainty and fear. These trends, in turn, should allow more investors to move back into the markets.

 

The primary source of risk has been, and remains, the sovereigndebt crisis in Europe. We believe European policymakers will do what is needed to avoid an outright catastrophe or a disintegration of the European Monetary Union, but we are not expecting to see wholesale solutions to the issues plaguing the region. The economic outlook for Europe is a poor one and has been made worse by austerity measures that are required for sovereign-debt issuers to maintain or regain investor confidence.