- European Rally to continue

I am convinced that the great start of the year (with European equities having the best start of the year since 1998) will continue in 2012. This because much of the banking crisis has been solved by the ECB bazooka where European banks are taking advantage of the carry trade with Sovereign European bonds and could increase their usage of the ECB facility to 1 trillion Euro in February.

There is a strong connection between the European banking crisis and Sovereign debt crisis and, provided that Europe carries on with their budget austerity measures and that Greece does not default, the rally could well continue throughout 2012.

- Political Uncertainty is still the main issue

This positivity about Europe and European equities depends on the resolution by mid February of the Greek problem. The political slow motion decision making is once again impacting the markets: doubts about a possible default of Greece have added pressure to Portugal and other countries. The political situation remains the biggest unknown. But to save the Euro a solution for peripheral countries has to be reached as soon as possible.
This solution, to be credible and sustainable, will have to include an higher degree of oversight like an EU commissioner as part of a solid fiscal pact.

- A Default could trigger a bigger crisis

I am of the opinion that a Greek default would easily spread across Europe with a bigger crisis of confidence that will be very difficult to contain. Such a crisis could possibly lead to serious consequences for the single currency.

Such a default would also impact both the ECB and other European banks with several banks failures that will force Governments to nationalize them. It would also intensify the crisis in the defaulting country making any hope for a recovery even more arduous.

- Mass Downgrades: Is Europe Doing something wrong ?

It was expected and, to some degree, it was already priced in by the markets. But the mass S&P downgrades of Friday are certainly ill-timed. Just this week we had a considerable improvements in both Spanish and Italian auctions. This improvement could now be jeopardized by a negative outlook that could be the prelude to further downgrades.

S&P criticized the policy response. I would say that many European countries are already in the process of enacting important reforms and need more time to address the problem. The downgrades were expected since the S&P downgrade of the U.S.
It was completely inconsistent to have U.S. with a AA+ rating and some European countries like France and Austria with a AAA rating so, in a way, the S&P downgrade more backward looking. While in the short term this downgrade might impact the markets
I do not see this a game changer in the European reform process.

- Greece has to avoid default

Greece has to do whatever it takes to negotiate a restructuring of its debt without defaulting. It is rumored that a number of creditors might would want a default to be able to claim compensation from the CDS but this would have very negative consequences for the European markets and for Greece.

The European reform can only proceed with the conditions that all the Euro-zone countries are not forced out of the single currency. A default of Greece, even if not a major event, would impact negatively every other European market and put further pressure on the yields of Spain and Italy.

- Cash is King in equities selection

Despite the renewed market uncertainties I still see equities of cash-rich companies as a good buying opportunity that becomes very relevant in an zero interest (or negative interest) environment in bonds. I would therefore renew my recommendation toward equities in European multinationals with fortress balance sheets and exposure to emerging markets and growth areas.

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No Global Recession, the end of the European Crisis in 2012
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Markets in 2012 started with a rally and this is not surprising as equities, especially European ones, are priced for a global recession or a meltdown of the euro and both events will not occur in 2012.

Positive economic data from India, China and the U.S. confirm that we are not heading for a global recession.
While the European situation remains fragile many companies are already pricing in a European recession and are therefore attractive.

The U.S. Economy is very likely to rebound in 2012 making U.S. equities attractive too.

European markets are largely oversold and still present a good buying opportunity for 2012.

While a final resolution of the European Crisis might not materialize immediately many of the austerity measures, like in the case of Italy, have already been enacted and this will help in restoring investors confidence. With the European bank liquidity issue being now solved by the ECB measures I expect Italian and Spanish bond yields to normalize soon. Some Europeans markets, like the DAX, experienced step declines in 2011 and are likely to recover in 2012.

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Commodities rebound in 2012
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Commodities have also an upside potential in 2012 as many of the demand supply imbalances have not been solved and while commodities were priced for a semi-recession growth from markets like China and India and political uncertainties (in the case of Oil) will help the market to rebound.

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Gold Still a winner in 2011 and a good hedge in 2012
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Despite the high volatility of 2011 Gold closed up 10%. Toward the end of the year several funds had to sell gold to meet redemptions and many investors wanted to cash in the profits but the reasons for which Gold has been a good portfolio hedge remain intact in 2012 and can be even stronger if more QA appears into the markets. I still recommend Gold or precious metals as a way to hedge a portfolio in 2012.

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The ECB "Bazooka"
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The ECB "bazooka" came in form of unlimited, low interest, long term 3 years loans to European banks. While this is not what the market wanted (a blanked guarantee or unlimited purchase of European Sovereigns) the latest ECB move solves the big problem of bank refinancing in 2012. This also reduced or neutralized the risk that European banks would stop lending with catastrophic consequences for the already fragile European economies.

As the Sovereign crisis is in many regards a crisis of confidence it could also be that many European mid size and small banks will take advantage of the carry trade and start buying European Government bonds more aggressively.

While this might not be sufficient in the long term if we combine this action with the long term debt reduction austerity measures undertaken by many Governments, like Italy, by restoring confidence in the market it could be helpful in leading to final resolution of the crisis in 2012.

End of the Crisis in 2012
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I see the end of the European crisis in 2012. This will happen after the first quarter that will remain volatile. This because Europe, due to their unique decision making structure, needs time to achieve fiscal unity. This does not mean that 2012 will be an easy year. There are still many unknown variables and risks:
1) Political risk: given the broad consensus needed to take any decision the political risk (and change of sentiment) remains the highest;
2) Further downgrades might force more drastic actions;
3) Banks could use the new facility for their own needs and limit their exposure to Sovereigns and limit their lending to small and mid size companies.

To solve the crisis in 2012 we need not just a wall of money for the banks but a wall of money, through loans, transferred to the real economy.

The improving U.S. Economy will also help in avoiding a global crisis.

Capital Wanted. Urgently.
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As European banks are under further pressure to raise 114 billions by June and reach a 9% Tier 1 capital European markets are and will be under further pressure. The deleveraging process has already started with several European banks selling profitable operations or reducing their presence in Eastern Europe and Latin America. The current need of recapitalization is not an isolated problem of peripheral Europe but includes German and French banks.

In this environment of forced deleveraging European banks might limit their future profitability and limit their future growth. There can be no resolution of the European crisis without first tackling the banking recapitalization issues.

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Austerity and Fiscal Union might not be the right answer
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The fiscal union pact fell short of of both the market and ECB expectations. I don't think that the action taken by European leaders was sufficient to lead to a prompt resolution of the European crisis.

Politicians are essentially trying, once again, to ignore the markets and progress with their plan of austerity. But austerity with negative GDP growth is hardly the right remedy to reinstate economic growth and competitiveness. The treaty changes vetoed by the UK are facing further obstacles from Hungary and Czech republic signaling that the route to a fiscal union is not as short as expected.

Europe in the long and short term
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While in the long term some of the solution presented at the summit might restore European credibility I don't think that the Government refinancing situation will be sustainable without a more decisive, concerted action. Europe has to work both on both a short and long term solution and, essentially, end with decisive action the crisis of confidence is facing.

Despite the very difficult environment investors can benefit from low valuations and focus on selective equities with good growth prospectives and simple business models - balancesheets. Some banks with a stronger capital base might also be a good opportunity. Gold might also resume its rally in 2012.

Strategy: In short
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- The European banking crisis is very much interconnected with the European Sovereign debt crisis so until the process of recapitalization is completed there will still be high volatility and uncertainties.
- European fiscal union is still far from being a concrete reality. European leaders should work on both a short term financing solution and a long term fiscal one.
- Opportunities abound but the best risk/reward is probably represented by companies paying consistently high dividends, good growth prospectives and a simple business models.