Investment Outlook
Investment Outlook - January 2012
As we welcome in the New Year with a record world population of 7 billion, has the outlook for investments changed? Fuelled by very downbeat media coverage in which market falls, political discord and corporate liquidations have been afforded full coverage, many may be of the opinion that an already miserable outlook has worsened still. It is important to remember however, that, whilst economies and markets are interlinked, they remain very distinct entities with differing fundamentals and drivers. It is evident that economic conditions have not improved, but nor have they dramatically deteriorated. Bad news is often an editor’s easy sell. Yet despite the media’s forceful economic diatribe and its apparent effect on sentiment, markets have been stoic in their resilience - a fact that, as ever, the media has been less prone to report. Our outlook is little changed. We believe that a lack of resolution in key political and economic matters will serve to perpetuate uncertainty and volatility, leading greed and fear to dominate market dynamics, but that these conditions lend themselves to investment opportunity for the more astute long-term investor.
With much hope pinned on each successive European summit providing clarity on the outlook for the region, the euro zone remains a thorn in the global economy’s side. The next summit at the end of January is expected to focus on growth initiatives and employment, but continued failure to provide any further clarity, particularly with regard to solving the euro zone’s sovereign debt crisis and the ECB’s crucial role in this, will likely see the region (possibly with the exception of Germany) move back into recession in the New Year and through the second quarter of 2012. What impact this will have on markets is moot. Arguably, these concerns have been priced in and markets could firm from here if investors’ worst fears do not materialise, but acute risk aversion and short termism could see a further retrenchment.
In the near term, having been surprisingly resilient to date, the euro is expected to weaken. Of concern is the future and possible dissolution of the single currency, which we believe has not yet been fully discounted in exchange rates. Capital has already begun to flow out of the more troubled euro zone economies and this could accelerate in the short term. In light of the outlook for the global economy, we see the US dollar as a likely beneficiary given its tendency to perform well in an environment of risk aversion and a lack of credible developed currency alternatives. Falls in the euro could compound this. We anticipate sterling to appreciate relative to the euro, but underperform the dollar. Following a period of strong returns and a retrenchment in risk appetites, many emerging market currencies now look oversold, with the notable exception of the yen. In the coming months, we expect this dynamic to reverse, particularly for the renminbi and with the exception of emerging European currencies given their proximity to the euro.
Slowing but still well in excess of western economies, growth and wealth in emerging market economies underpins a continued shift in power from west to east in matters both economic and financial. Armed with superior fundamentals, a range of policy options and well-founded confidence, these economies enter 2012 in much better shape than their western counterparts. A recession in Europe will certainly dampen growth, particularly in Asia, as short term gains in domestic consumption fall short in offsetting weakening demand for these still very export driven economies. Over the longer term however, the catalysts of a growing middle class, rising incomes, new trade corridors and a move up the value curve are expected to help drive the global economy. Throughout the year waning risk appetites have led to an outflow of investor capital from many of these markets. Valuations consequently look undemanding making for some attractive entry and cost averaging opportunities over the longer term.
With pressure for resolving widening global imbalances resting on the shoulders of deficit countries, growth in the US and UK is expected, at best, to be sluggish for the next twelve months with the most significant gains made in the second half of this year. In the UK, talk of further quantitative easing as a means for supporting asset and property prices continues but, with its value called more and more into question with each successive round, actual implementation may prove unpopular. Concerns that these programmes would result in inflationary pressure have for the time being been allayed as inflation in the US, and now in the UK, appears to have peaked. From here, spare capacity and falling wages are likely to lead to a period of disinflation. Without assistance from the super-saver nations in reinvigorating their domestic demand, this deflationary bias could dominate in the coming years. Two to three years out however, as emerging markets, and in particular China, once again find their feet, imported wage demands, rising input cost pressures and a lagging quantitative easing effect could reignite inflation and the west may once again find itself economically compromised. If in response further programmes of fiscal austerity were undertaken, concerns of a rise in protectionism and civil unrest could re-emerge.
Markets in the US and UK are therefore expected to continue their bumpy path through 2012. The housing market in the US remains an obstacle in the pursuit of recovery whilst in the UK the large levels of debt, proximity of Europe, a gelded financial services sector and faltering consumption undercut both growth and confidence. Low growth and receding inflation forecasts in the short term will likely result in a period of easy monetary policy and low government bond yields across major developed markets. Having performed well in 2011, we believe that sovereign debt markets are unlikely to achieve much in the way of capital return through 2012, albeit for many investors their diversifying nature remains an important portfolio construction tool.
With cash also offering little real return, we believe that equities continue to offer the more compelling investment case. Across a number of metrics, equity markets look cheap at current levels as risk aversion and sentiment driven investing led equities, particularly in emerging markets, to underperform other risk assets in 2011. Concerns surrounding earnings estimates and profit margins are important and bottom up global earnings growth forecasts of around 10% within an environment of 2.5% global GDP growth, might prove a little optimistic. Nevertheless, there is disparity between analyst expectations and the market, with the latter appearing to discount falls in earnings this year. Of course some companies will continue to struggle and, from here, discerning the justifiably expensive from the overbought and the deep value from the value trap will be key. For those with long time horizons, we believe opportunity remains and we continue to favour blue chip, multinational companies with solid balance sheets, strong cash flow and the comfort of a good yield.
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