Worldwide: Investment Outlook - A Monthly Round-Up Of Global Markets And Trends

Last Updated: 18 January 2013
Article by Smith & Williamson

Investment review

A positive end to the year

Global financial markets breathed a sigh of relief as lawmakers in the United States reached a last minute deal to pull the US economy back from the brink of its so-called 'fiscal cliff' and expectations for the global economy edged higher.

World

The deal in Washington, hammered out over the Christmas and New Year holiday period, sees Bush era tax cuts extended for the majority of taxpayers, while the automatic public spending cuts that were threatened in the absence of an agreement have been deferred for another two months, until the beginning of March. The road towards a deal has been both fractious and laboured, with negotiations exposing the inability of Congress to set aside party differences for the good of the wider economy. The failure of Congressional leaders to resolve the public spending element in the 'fiscal cliff' negotiations will prolong uncertainty about a key part of the budget outlook, leaving further scope for brinkmanship on both sides of the political divide. Nevertheless most investors appear to believe that common sense and practicality will eventually produce a settlement of this long-running issue, prompting a global 'relief rally' in many risk assets.

2012 proved to be a strong year for the contrarian investor. Unloved sectors such as banks enjoyed a strong performance in the second half of the year as fears of a breakdown in the eurozone receded, reducing the risk of a systemic banking crisis in Europe. Signs of a recovery in Chinese growth following the regime change in Beijing also helped to boost mining and other cyclical stocks, while pushing government bond yields in the UK and US higher. Contrarian strategies tend to perform well during periods of major economic turning points, so a central question going into 2013 is whether the recent return of risk appetite marks the start of a prolonged period of improvement in the economic and financial outlook, or merely a temporary turn for the better. With yields on UK gilts, US treasuries and German bunds all still trading near all time lows, there is limited potential for further capital growth, and scope for losses if the recent pick up in yields were to continue. We remain of the view that inflationary pressures will reappear in the longer term, but not yet.

UK

Despite a gloomy economic backdrop, the FTSE 100 has broken through the 6,000 mark and is nearing two-year highs. The market's resilience is in contrast to an economy that continues to crawl along the bottom and remains over 3% below its pre-recession peak. On a more positive note, the UK appears to be holding up better than many of its eurozone counterparts. The Bank of England has forecast growth of around 1% in 2013: if correct, that implies the UK will avoid the recession that is currently afflicting most of the rest of mainland Europe. If the threat of a near-term eurozone break up has retreated, as the markets appear now to be assuming, any stabilisation of the economic climate on the continent should benefit UK trade. With a new governor taking over at the Bank of England later this year, we may see a more aggressive easing of monetary policy to help boost the sluggish economy. The Funding for Lending Scheme launched in June last year has begun to boost mortgage lending, one of the keys to increasing the availability of credit to the wider economy.

The impact of the Bank of England's £375 billion in Quantitative Easing (QE) has been the subject of debate, with a number of members of the Bank's Monetary Policy Committee questioning whether QE in its current form will be as effective as before in boosting the economy. With bond yields edging up since the summer of 2012, one critical issue this year will be whether the UK can retain its cherished AAA sovereign debt rating. A notable feature of the UK equity market in 2012 was the outperformance of small cap stocks relative to the FTSE 100 index. This could change in 2013. The FTSE 100 remains highly skewed towards the energy and mining sectors, so any pick up in industrial activity, especially in China, could also be positive for the large cap index. UK stocks appear well placed to take advantage of an upturn in production.

US

US policymakers have a habit of leaving things to the last minute, and the fiscal cliff negotiations were no exception. As with the eleventh hour debt ceiling deal last summer, it was only right against the deadline that both Houses of Congress approved the deal to avoid the US slipping off the fiscal cliff and the economy plunging back into recession. The deal moderates tax increases and spending cuts that would have seen around $600 billion wiped off US GDP in the coming year. The Bush tax cuts have been made permanent for around 99% of households, with the Republicans giving way by approving a tax increase on those earning in excess of $400,000, which economists estimate may cut GDP by 0.5%-0.7% in 2013. Tax seems to have been the sticking point in the heated end of-year discussions. Decisions on automatic spending cuts, an even more contentious issue, have been delayed for another two months, deferring a resolution to the issue.

The deal announced on 1 January also failed to address the issue of the Federal debt ceiling, which looks likely to be breached by the beginning of March. That means Democrats and Republicans will therefore need to return to the negotiating table towards the end of February. With Republicans having made concessions over income tax increases, it seems clear that they will attempt to use the debt ceiling as leverage to extract higher spending cuts in the negotiations. Another failure to reach an enduring agreement on public spending cuts would put the US Government's credit rating under further pressure.

Nevertheless the initial positive reaction of equity markets to the New Year announcement does not look unreasonable. There could be further appetite for risk assets if a comprehensive deal can be reached in the spring. The hope is that, with the outlook now a little clearer, companies and households will put the large amounts of cash sitting on the sidelines to economic use. Potentially this could provide a significant boost to the US economy and drive equity markets higher. Any substantial revival in capital expenditure is unlikely however until the debt ceiling issue has been addressed. The markets will also be looking for clearer evidence of the direction of monetary policy in the United States, given the ongoing debate over the effectiveness of QE. Despite improving sentiment, valuations in some sectors look quite high and the S&P 500 is trading at the top of its post-2008 trading range. A key question for 2013 will be whether the US market can break out decisively from this range.

Europe

The period of relative calm in Europe has continued into the New Year. The breathing space created by the European Central Bank's actions and pledges in 2012, combined with the eventual signing of Greece's interim loan agreement, has helped to remove much of the systemic risk and improved investor sentiment towards the region. Europe's cyclical sectors have outperformed in the final quarter of the year, acting as high beta plays on European market performance. However policymakers still face another tough year in 2013, with leading economic indicators suggesting that the region will fall further into recession in the coming months. Growth in the stronger Northern nations such as Germany looks increasingly vulnerable. Domestically focused companies will struggle to thrive in an environment where the ECB has forecast growth could contract by as much as 0.9% in 2013. Europe's exporters have greater exposure to emerging markets and should benefit from the higher growth in those markets.

While the US fiscal cliff deal has excited equity markets and kept the eurozone off the front pages throughout December, the focus will in due course shift back to February's Italian general election, the early struggles of the new French government and continued speculation about an eventual bailout for Spain. While the ECB's promise of Outright Monetary Transactions (OMTs) has helped lower Spanish 10-year bond yields to a 12 month low of around 5%, the €14 billion in bond repayments due on 31 January and €15 billion on 30 April will put pressure on the Rajoy government to seek assistance, something it has so far successfully resisted. European equity funds experienced net outflows of more than €20 billion in 2012, underlining the challenges that still face the region.

Asia

Japan

Japanese equity markets have welcomed the crushing defeat of Prime Minister Yoshihiko Noda's Democratic Party of Japan (DJP) in the December general election and the election of a new government led by Shinzo Abe's Liberal Democratic Party (LDP). The Nikkei index of leading shares has risen by more than 20% since mid- November, on the expectation, and now confirmation, that the LDP would take back power from the DJP, which has led the country since 2009. The yen, which until recently was trading a mere hair's breadth away from its post-war high, has also fallen sharply against all major currencies, including the dollar. Mr Abe's large majority in the Lower House, combined with his manifesto commitment to push for a higher inflation target and more aggressive monetary easing by the Bank of Japan, have convinced markets that he means business. With the economy now experiencing its fourth recession in 12 years, however, reality now needs to catch up with expectations. Mr Abe's public spending promises may prove hard to deliver, given the government's precarious debt position, and his hard-line stance on the territorial dispute with China will remain a cause for concern. Nevertheless, with valuations not looking stretched and renewed optimism surrounding the nation's new leadership, the recent good run in Japanese equities may have further to go. Further yen weakness would certainly help Japan's large export firms, which make up an important proportion of Japanese stock markets.

China

With global growth expected to remain subdued in the coming year, the focus for financial markets will be on China's economic recovery and transition. The economy ended 2012 on a positive note, with both the official and HSBC purchasing managers indices continuing to climb above the all-important 'expansion' level. While we are unlikely to see growth back to the 10% rate seen in the past decade, there has been a notable pick up in momentum in the last quarter. The new government has increased infrastructure spending. GDP growth should rise in 2013. With the policy focus shifting towards boosting Chinese consumption and industrial production, the Chinese equity market could become an exciting place to invest in 2013. The new government is likely to continue with measures aimed at reviving the A-Share market and improving accessibility for both domestic and foreign investors. Sectors that are likely to benefit from the new regime's policy priorities are consumer goods, industrials and pharmaceuticals. A-Share valuations are currently at a historically attractive range, making the market one to watch in 2013.

Are gilt yields bottoming out?

2012 was a year when the yield on UK government bond yields fell to all-time historic lows, with the benchmark 10-year gilt yield touching 1.5% in the middle of the year. Despite moving back up to around 2.0% at the end of the year, trimming earlier capital gains, yields from conventional gilts remain barely half the level they were at the start of 2011. The 'real yield' on government debt, after taking account of inflation, meanwhile remains around zero. Some shorter-dated index-linked gilts even have negative real yields. A key question for 2013 is whether gilt yields have finally bottomed out, bringing to an end what has been a 30-year bull market in the price of government debt.


Revival for banks and mining stocks

The second half of 2012 was marked by a recovery in the price of both financial and mining stocks, which since the financial crisis have become the two sectors of the market most sensitive to changes in investor sentiment. Their recovery underlines the improvement in professional investor sentiment since the summer, triggered initially by the European Central Bank's effective intervention in the eurozone debt crisis, and subsequently by perceptions that the risk of policy failures may be beginning to recede. Overall the FTSE All-Share index finished the year ahead of where it started, producing a total return (including dividends) of 12%, against just under 3% for gilts.


Gold and the price of shares

The long term fortunes of equities can be usefully measured against the price of gold, a valuation measure popular with many analysts. The chart shows how the level of the Dow Jones Industrial Average, the first general US market index to be widely followed, has changed since the 1920s, when measured in terms of gold rather than dollars. It shows that an ounce of gold today buys less than a quarter of the shares it would have bought at the peak of the equity market in the year 2000, underlining how far the price that investors are prepared to pay for equities and other financial assets has fallen relative to physical assets.

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