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Oct. 14, 2011, 11:15 a.m. EDT

7 surprise risks to your money in 2012

What to do about recession, debt, social unrest and other market disorders

SAN FRANCISCO (MarketWatch) — Investment strategists typically draw a base case for the global markets and also an outside case — low-probability events called “tail risk” that are more “what if?” than “what now?” situations.

But nowadays market volatility has grabbed investors by the tail, and risk-management is front and center. With uncertainty and unrest spreading from Athens to Manhattan’s Zuccotti Park, analysts at Bank of America Merrill Lynch thought it timely to assess some potential tail risks that could develop in 2012, and tell investors how to take advantage of them.

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The base case for Merrill Lynch analysts is a relatively optimistic scenario. Here, the global economy slows but avoids recession, emerging markets post respectable growth and China and the U.S. muddle through their economic troubles, said Kate Moore, a Merrill global strategist who contributed to the recent research report.

“The prevailing assumption is that companies are going to struggle and we’re going to grind to a halt,” she said. “That’s not how we view the world.”

While the global economy will likely show much lower growth, some companies will weather the storm, Moore noted. In that environment, high-quality, income-producing stocks will be coveted. Said Moore: “There’s definitely an opportunity to take advantage of companies that will do well.”

Generally, a tail risk has a 1-in-10 chance of occurring, but if and when it happens the impact on investment portfolios can be substantial, the Merrill report said. Here are seven scenarios the analysts said investors might see in 2012, and what you can do about them:

1. The Fed hikes interest rates

The idea that the U.S. economy would strengthen enough for the Federal Reserve to raise rates in 2012 strikes most observers as farfetched, if not ridiculous.

“It’s a good thing to think outside the box, but that’s in outer space,” said Ed Yardeni, president of market strategy firm Yardeni Research.

The Merrill strategists don’t disagree — in fact their models indicate that the U.S. economy won’t be strong enough to support a Fed rate hike until the third quarter of 2014. But that doesn’t mean a rosy picture is out of the question.

“It’s not a zero-probability event,” Moore said. “The big surprise would be that the economy has bigger and stronger growth than we and the rest of the market expects.”

Catalysts for U.S. economic growth would include election-year cooperation in Washington on spending and deficit reduction, and low mortgage rates spurring home sales and buoying the banking sector.

What to do

Whenever the Fed does hike rates, look for stocks to outperform bonds. Specifically, investors should then favor U.S. equities over emerging markets and domestically focused small-caps would trump globally oriented large-caps, the Merrill report said. 

Municipal bonds do better than Treasurys, while corporate bonds and gold would come under pressure.

2. Social unrest rises

Seeds of social unrest are sprouting worldwide. In the U.S., the fertilizer is double-digit unemployment while income inequality between the wealthiest Americans and average citizens hit a level not seen since just before the Great Depression.

Jeffrey Gundlach, the bond-fund manager and CEO of Los Angeles-based investment firm DoubleLine Capital LP, offered this view of the Occupy Wall Street protests: The average American doesn’t watch the stock market day to day, he said, but “they do know something is wrong when the library is closed on Thursdays, the potholes aren’t getting fixed, big corporations are doing well and the CEOs look relaxed and tanned.” So they are protesting “income polarization and policies that support it.”

Read our Occupy Wall Street protest blog.

What to do

Social unrest is one tail risk that appears to be growing. The development doesn’t bode well for most stocks, as it reflects deteriorating economic conditions, a stretched consumer, austerity in the absence of growth to repay debt and a lack of leadership and 

collective will to put people back to work.

The Merrill research noted that protests around the world create an environment that favors bonds over equities, and defensive stocks over cyclical stocks that would benefit from a clearer economic picture.

Treasurys are favored over corporate bonds, and in a more volatile world, safe-haven assets such as gold and a play on food scarcity through agriculture and agribusiness shares would be warranted.

For gold exposure, investors could consider an exchange-traded fund such as SPDR Gold Trust IAU +0.68% , iShares Gold Trust GLD +0.27% and Market Vectors ETF Trust Market Vectors Gold Miners GDX +0.06%  , while one agriculture ETF to investigate would be PowerShares DB Agriculture Fund DBA +1.23% . 

3. China’s economy makes a ‘hard landing’

Worries are mounting that China’s high-speed economy will slow and what the world wants to know is, how much?

Data shows that China’s exports and imports are contracting, a likely result of Beijing’s efforts to shackle inflation. This suggests that the world’s second-largest economy may be a less-powerful growth engine going forward — and is even contributing to global weakness.

A “soft landing” for an economy, where central bankers skillfully and gradually brake inflation, is greatly desirable but highly atypical. Critics say China’s task is complicated by an oversupply of real estate development and infrastructure projects, and a banking system exposed to a large swath of this questionable debt.

“The pieces are lining up for a hard landing,” said Vikram Mansharamani, author of “Boombustology: Spotting Financial Bubbles Before They Burst.” Policy makers in China, he added, are “stuck in a place between fighting inflation and an inevitable slowdown.”

What to do

A China hard landing would be tougher on China’s suppliers than China itself, Mansharamani said. That prospect has already derailed investors in resource-rich Australia, Brazil and emerging Asian countries that furnish China with oil, copper, steel and other and commodities that have fueled the Chinese economic miracle.

Not just the resource countries, but emerging-market stocks and currencies worldwide would feel the knock-on effect of a hard landing, the Merrill report said. Money would then flow to defensive assets in the U.S., Europe and Japan, chiefly the U.S. dollarDXY -0.60%  and high-quality corporate and government bonds, plus gold.

4. Greek debt woes spread

Markets are largely pricing in an “orderly” Greek debt default. In this best case, European leaders orchestrate what’s politely called a “restructuring” of Greek government bonds, avoid contagion to Italy and other periphery countries’ debt, and recapitalize or possibly nationalize important European banks with heavy exposure to these problem assets. In this scenario, stocks and the euro show long-term resilience.

The outlying risk Merrill raises is that Greece instead suffers a “disorderly” default on its debt, which spills over to Italy, Spain, Portugal and Ireland.

Signs of trouble to watch: the euro nosedives and Italian government bond yields spike. As the situation deteriorates, periphery European governments balk at austerity measures, the euro zone splinters, and the bond market looks askance at slow-growth conditions in the U.S., U.K. and Japan.

What to do

In the event of a disorderly default, stocks would suffer deeply, especially the financial sector. Corporate bonds, energy and industrials would be hurt as well, along with anything related to the euro. Money would flock to safe havens, especially Treasurys, gold and the U.S. dollar.

“If Spain and Italy get hit with a massive loss of confidence, and they’re next in the line of dominoes, then it probably is ‘game over’ as far as the euro zone is concerned,” said David Rosenberg, chief economist and strategist at Toronto-based investment manager Gluskin Sheff + Associates. Read more: Economist Rosenberg warns of coming U.S. deflation.

5. Trade war erupts

The allegation that China is manipulating its currency, keeping the yuan artificially weak to benefit its export-oriented manufacturers, is gathering steam in Congress and on the presidential campaign trail.

Fear of a global recession only sharpens the political finger-pointing. Said Moore, the Merrill analyst, “It’s easier to name an external enemy than to deal with the problems domestically.”

If the U.S. and Europe fight recession with protectionism, and China retaliates with tariffs on Western goods, a full-blown trade war becomes a real possibility, the Merrill report noted. This could lead to stagflation, which is a truly miserable combination of rising prices and slow economic growth.

What to do

A breakdown of global trade would leave China, Japan, Germany, South Korea and Singapore particularly vulnerable, the Merrill report said.

Stagflation would be a negative for both corporate bonds and stocks, the Merrill report said, though domestically oriented U.S. small-cap shares, such as those reflected in the Russell 2000 Index RUT +1.95%   would fare better than the large-cap multinationals found in the Dow Jones Industrial Average DJIA +1.45%  and the Standard & Poor’s 500-stock index SPX +1.74% . The big winner from stagflation: gold.

6. Active managers outperform ETFs

Exchange-traded funds — indexed portfolios that trade like stocks — have become enormously popular with institutions and individuals, at the expense of both common stocks and active management. Above-average market volatility and stocks moving in tandem have boosted ETFs’ appeal and made it difficult for independent stock pickers to add value.

Greater stability in the financial markets would warm the climate for active management and enable more stock-fund managers to outperform a benchmark index, Moore said.

“We don’t think that all the stocks in these indexes are created equal,” Moore said. “There’s an argument to be made for active managers in this environment who are able to delineate between higher-quality companies with growth opportunities and the rest of the universe that may languish.”

What to do

In a stock-pickers’ market, investors should favor sectors that are less sensitive to overall market moves, the Merrill report advised. These areas include retail, software, technology, leisure and education stocks.

Conversely, the report noted that sectors driven by broad economic reports rather than company fundamentals should be avoided, including transportation, insurance, real estate, capital goods and utilities.

7. Market leadership narrows

In a Darwinian type of market, where only the strongest survive, pessimistic investors gravitate to the biggest and best-equipped lifeboats. Before long, shares of these “best of breed” companies get expensive.

The Merrill report sketches a case where the sovereign debt crisis leads to global recession, which spurs investors to hold shares of a rarefied group of stalwart large-cap companies. Accompanying this narrow leadership is a range-bound market plagued by persistently weak growth and ineffective central bank action.

“Everyone is going to recognize this theme and how valuable these companies are, and get focused on them,” Moore said. At that point, the danger of a bubble in these stocks is higher, as happened with Japanese stocks in the 1990s and the high-flying “Nifty 50” U.S. companies in the early 1970s.

What to do

Ride the market leaders on their upward trajectory through high-growth, high-quality sectors including technology, industrials and consumer staples, the Merrill analysts said.

Just don’t overstay your welcome. “Identify those areas that are not being driven by that increasingly crowded trade,” said Mark Luschini, chief investment strategist at Janney Montgomery Scott. “You’d want to be leaving that which has been discovered and rotate into that which is uncovered.” 

Jonathan Burton is MarketWatch's money and investing editor, based in San Francisco.