Worldwide: Investment Review - Hopes And Fears For 2013

Last Updated: 21 December 2012
Article by Smith & Williamson

Barack Obama's victory in the US Presidential elections and the peaceful change in China's leadership has removed some uncertainties, but investors are still waiting for a clearer lead on a range of other issues as we head into the New Year.

World

Barack Obama's return to the White House confirmed that Ben Bernanke would remain at his post as Chairman of the Federal Reserve for at least another 12 months. The markets' focus has now switched to whether Democrats and Republicans can set aside their differences and address the looming 'fiscal cliff' that threatens to derail the US economic recovery. Investors appear to be becoming more optimistic that a deal can be reached in time, with a 'watered down' version of spending cuts and tax hikes the most probable way forward.

In Europe, the latest deal to resolve Greece's economic crisis seems set to produce further breathing space for the euro and buy more time for the Government to bring its mounting debt back to more sustainable levels. Markets have also reacted positively to recent encouraging data from China which suggests that the world's second largest economy has stabilised after a decline in its economic growth rate.

These positive developments have to be set against the reality that economic growth is still well below the levels expected two years ago and a number of key issues – not just in Europe but also in Japan and the US – remain to be resolved. Growth fears may well resurface in 2013, which in turn will return the focus to the resilience of company earnings and questions about the policy intentions of central banks and governments. Bond yields in so-called 'safe haven' countries remain close to all-time lows, reflecting the fact that the majority of investors have yet to be convinced that the worst is behind us.

UK

The strong 1% third quarter GDP figure which many expected to prove too optimistic has been left unrevised, news that will please Chancellor George Osborne. With public sector borrowing continuing to run ahead of target, the Treasury has been given a much needed helping hand by the Bank of England, which has agreed to hand over around £35bn of cash from its asset purchase facility to the Treasury by next April. The move could signal an end to the central bank's perseverance with its current method of QE; a number of members of the Bank's monetary policy committee are questioning the effectiveness of its bond purchasing programme.

The Chancellor's announcement that Mark Carney, the current governor at the Bank of Canada, is to replace Mervyn King at the Bank of England next year came as a surprise, but has been broadly welcomed. His arrival comes at a critical moment for the central bank, which has been given increased regulatory powers while continuing to navigate the UK economy towards renewed economic growth. Investors will need to remain vigilant for any signs that a change in monetary policy is imminent.

The headline performance of the UK equity market remains disappointing. Unlike almost all other major regions, the UK equity market has seen significant outperformance by smaller capitalisation companies (up 22% on average year to date). Three key sectors in the FTSE 100 index – basic materials, healthcare, and oil and gas – have underperformed comparable sectors in other regional markets, leaving the index lagging comparable headline national indices. While the outlook for commodities remains uncertain, the UK's large mining companies could be well placed to benefit from signs of an improvement in Far East economies.

US

With the election campaign now behind us the focus for markets is firmly on the looming fiscal cliff. Recent economic data has been mixed, suggesting that the economy is feeling the impact of last month's Hurricane Sandy. We continue to believe that the US economy is on the right path. Steady improvements in the housing and labour markets are beginning to filter through into consumer confidence; the University of Michigan Consumer Confidence Survey has risen to its highest level since mid-2007. In contrast to the UK and Europe, credit growth has been increasing, suggesting that the Federal Reserve's quantitative easing (QE) and ultra-loose monetary policy is having a positive impact on the real economy. However, the lack of confidence among US corporations remains a cause for concern. The Federal Reserve's flow of funds data suggests companies are no longer hoarding cash, but are unlikely to increase capital expenditure until an agreement on the fiscal cliff has been reached and managements can begin to plan again with confidence.

There have been some initial signs of progress in negotiations between the White House and the Republican-led House of Representatives. We remain optimistic that a workable agreement can be reached. The Bipartisan Policy Centre calculates that the US Treasury will hit its permissible debt ceiling by 1 March 2013, so the need for a resolution is becoming urgent. While US equity markets have moved little over the past month, sectors directly impacted by planned spending cuts, such as health care and defence, are likely to remain volatile as the deadline approaches. Following a relatively disappointing third quarter earnings season, another question mark hangs over the likely trend in company profits in 2013.

Europe

Concerns over Greece's future in the eurozone came to a head once again in November, only to ease when finance ministers patched together a revised bailout deal after another marathon session. If approved by a number of national parliaments, the latest agreement appears to remove the threat of an imminent Greek exit from the single currency, albeit at a cost of further financing from the wealthier nations in Europe. The agreement will allow Greece to tap a longawaited and much needed €34bn in aid. Disagreements between the EU, European Central Bank and International Monetary Fund were papered over in order to push through a last minute deal. The measures agreed include cutting interest rates on bilateral loans already made to Greece and reducing the cost of loans from the European Financial Stability Facility, the region's temporary bailout facility. The aim is to enable Greece to reduce decreasing the nation's debt-to-GDP ratio to a sustainable level within ten years. Although few expect that this can be achieved without a substantial write-off of existing loans, market reaction to the deal has been positive, with Greek ten-year bond yields falling to their lowest level since the debt restructuring in March. In Spain meanwhile, political tensions have increased following gains by pro-independence parties in the recent Catalonia elections.

While the Greek debt deal has been welcomed by markets, the economic landscape in Europe remains unchanged. Third quarter GDP data confirmed the region is now in a recession, and that the troubled nations in the south are falling further behind the stronger nations of the north. Although the poor economic data now appears to be factored into markets, many cyclical and domestically-focused companies will struggle to thrive in an environment where growth remains non-existent. The speed with which Europe can return to economic growth has become a critical issue for both the equity and bond markets, as well as for its political leaders. 2013 will be a critical year for the future of Europe and its political and economic ambitions.

Asia

Japanese equities have climbed to their highest level since early May on the back of further developments that could have long-term implications for Japanese politics. With the potential for Japan to fall off a 'fiscal cliff' of its own, Prime Minister Yoshihiko Noda finally agreed to hold a snap general election on 16 December. With his Democratic Party behind in the polls and low on popularity, this is likely to lead to a shift in power towards the right, with Shinzo Abe most likely to take over at the top. Mr Abe has long been an advocate for more aggressive action from the Bank of Japan to combat the deflation that has plagued the Japanese economy and rein in the strong yen.

Should Mr Abe and his Liberal Democratic Party succeed in December's elections he is likely to push for an inflation target of 2% (similar to that of the Bank of England and Federal Reserve) and policies aimed at anchoring the currency in a lower band, which would clearly help Japan's large export companies. Initial market reaction to the news has been positive with the yen weakening against the dollar and the equity market reversing its earlier falls. However, for a shift in sentiment toward Japanese equities to be sustained, policymakers will need to convince markets they are committed to improving Japan's deteriorating economic outlook. Recent history has shown this is not always the case.

The focus of global markets also remains on the flow of data from China, with more investors becoming convinced that a 'soft landing' is now taking place. With the new leadership now officially presented to the world, there is a growing expectation that they can begin to make the slow transition towards a more consumer-focused economy, without loosening their grip on control and minimising any social unrest. The fourth quarter has started well with industrial production and retail sales both increasing. The manufacturing Purchasing Managers' Index (a proxy for short-term growth) is once again signalling expansion lies ahead. Recent policies introduced by the Government, including increasing the overseas investment quota, could help to encourage further capital inflows. Chinese equities, as measured by the Shanghai Composite index, have however fallen to new multi-year lows, although the equity market in Hong Kong remains one of the year's best performers, up around 15% year to date, on a par with the main European indices.

Important note: This article summarises Smith & Williamson Investment Management's current assessment of recent developments in the global economy, but our investment managers have discretion to tailor individual portfolios to the specific needs and risk profiles of clients rather than follow a specific model.

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