The global economic outlook continues to be dominated by events in Europe. The optimism generated by the new European and Greek rescue package that supported a massive rally in financial markets in October has dissipated and given way to scepticism and political posturing. A Greek referendum proposal (since abandoned) and the resignation of the Greek and Italian Prime Ministers saw spreading bond market contagion with Italy at the epicentre. Italian bond yields pushed above 7% at one point, raising the prospect of default in the continent’s third largest economy.

It seems likely that Europe will be in recession in 2012. The issue is the whether the European sovereign credit crisis and the associated European banking crisis can be contained or prevented from turning into a significant global financial crisis. As noted above, Italy has become the focus and with a debt to GDP ratio of 120% and paying 3-4% real interest rates in an economy growing by only 1.5% per annum over the past decade, its debt position becomes unsustainable.

The US economy has managed to perform relatively well so far in the 2nd half of 2011. Consumption spending actually grew 2.4% in the September quarter while business investment remains solid. However, the prospect of tighter fiscal policy in 2012 and very weak household disposable income growth means growth will be hard to come by in 2012.

As we have seen in the UK and Japan, and most likely in the US in early 2012, central banks are engaging in additional QE measures. The ECB has also moved to cut rates and more cuts are expected. In China, the weaker growth environment and sliding inflation will likely permit an end to the tightening cycle and selective easing measures.

In some sense we have moved into a new phase of this current slowdown. Policy is now responding but it continues to be reactive and in the case of Europe, may already be too late to prevent a more serious downturn.

What transpires over the coming weeks and months will be critical to the economic environment and investment scenario confronting investors as we enter 2012. Strong ECB action to purchase unlimited amounts of European sovereign debt may well be necessary to shift Italian bond yields into a zone that allows time to devise and implement a strategy to reduce debt levels to more sustainable levels. In the US a “super committee” agreement on a credible medium term plan to reduce the budget deficit is required.

For now the situation is highly uncertain. Extreme economic scenarios are plausible and given that, extreme policy responses are not only required but also possible.

The core scenario remains one of low but volatile growth outcomes in the developed world with continued solid growth in emerging economies.