The situation in the eurozone will continue to dominate global markets next year, according to the Bank of America Merrill Lynch team, speaking at a press conference at the bank’s headquarters in New York yesterday.

The eurozone credit crisis, a loss of confidence and fiscal austerity “almost guarantee some kind of recession” in Europe, said Ethan Harris, co-head of the Bank of America Merrill Lynch team, at a press conference at the bank’s headquarters in New York yesterday.

There is only a 10 per cent probability that Europe will avoid a recession, and a subsequent global slowdown, Harris said, citing the firm’s Year Ahead Outlook report, also released yesterday. The study’s baseline forecast saw a 50 per cent chance of a European recession in 2012, with GDP in the eurozone declining 0.6 per cent and growing only 1.9 per cent in the US. And the other 40 per cent probability? Merrill described that scenario as downright “ugly.”

What’s more, Harris said he saw “a high risk” of a Greek debt default, responding to a question from Family Wealth Report, because the Greek government “can’t repay” its current level of debt unless some of the debt is forgiven. While a Greek default by itself isn’t worrisome, Harris said, the “collateral damage” to banks holding Greek bonds and other countries with high debt levels would be. “There would be no good outcome for periphery countries,” he said.

A worse-case scenario would be a Greek exit from the euro in “an uncontrolled fashion,” according to Harris, which would cause the recession to “get much worse.”

Austerity and uncertainty

New fiscal austerity and policy uncertainty will contribute to an economic slowdown in the US next year, according to the Merrill Lynch forecast. However, inflation was not expected to be an issue in the US (or most other countries) and the report also forecast “continued upside surprises in US data.”  For global investors looking for a safe haven, US Treasuries will remain “the only game in town” said Priya Misra, head of US rates strategy for Merrill Lynch global research.

Banks will continue to cut interest rates and European governments and the central bank will begin quantitative easing to stimulate the economy later in the year, Harris predicted. “The good news,” he said, “is that policy reaction will help cushion the blow.”

But the bad news, Harris added, is that the election of populist governments in Europe could make things worse.

Equity outlook

Equities will depend on bond performance, according to the Year Ahead Outlook.

“I don’t think you can have a good bull market in equities unless you have a major inflection point in bond yields,” said Kate Moore, Merrill’s senior global equity strategist. That will occur only when the US economy is strong enough for the Fed to raise policy rates, reflecting a recovery in real estate, banking and labor markets, according to the report. But in the near term, a policy rate hike “is not in the cards,” Moore said.

Merrill recommended “defensive positioning” in stocks going into the New Year, unless “comprehensive and credible” policy solutions emerge in Europe. But the firm also recommended that  investors “have confidence in adding alpha through stock selection in 2012” and pick stocks and sectors that provide high growth, high quality and high yield.

Still, it all comes back to Europe. “You have to get the macro right,” said Merrill’s head of global research Candace Browning, “if you want to get stock-picking right.”