Investors should take a more optimistic stance

In the early stages of 2012, indicators that drive investors’ asset allocation have strengthened significantly.

For all asset classes the investment signals are tilted towards taking risk. Momentum, sentiment and measures of health in the business cycle have all improved. The likelihood of added short-term stimulus and/or support for liquidity in the markets has also increased.

This justifies a more optimistic stance, albeit with a necessary dose of caution. European markets are still in danger of falling and remain the largest tail risk on the horizon. These risks have subsided somewhat in the past weeks on the back of the European Central Bank’s provision of three-year funding, as well as positive surprises in data from the euro area, albeit at depressed levels. Caution should therefore not completely override the more positive news from other areas of the market and the overall economy.

In light of fundamental and behavioural analysis and qualitative assessment of systemic risks, it would seem prudent for investors to adjust their stances to reflect this cautiously optimistic mood. The environment is sufficiently buoyant for investors to anticipate a positive risk-adjusted excess return from a modest overweight position in risky assets.

Market dynamics in recent weeks have illustrated investors’ renewed willingness to buy AAA-rated eurozone debt, with exposure to the risk of rising interest rates.

Government bond yields will remain low for the time being due to the very loose monetary policy in the G4 regions, while parts of the emerging world are veering in the direction of further easing. However, political turmoil could continue to trigger considerable swings in yields. Although European policymakers have taken steps in the right direction, the risk of a temporary loss of confidence among investors has not disappeared.

Within fixed income, the recent improvement in the market cycle and stronger sentiment and momentum indicators caused us to become more neutral on the outlook for spreads, or the gaps between yields on bonds. Within spreads, higher yielding assets remain well supported by the fundamentals underpinning the market, as well as momentum in terms of relative returns.

Given fading inflationary pressures and tentative signs of monetary easing, local developing world bond markets remain attractive.

Against the macroeconomic backdrop, corporate earnings are expected to decline, especially in Europe. The main reason is decreasing growth in revenues, which is a direct consequence of lower global economic growth, as well as diminishing profit margins. However, compared with previous recessions, there will only be a moderate profit decline this time. In general, companies are in good shape.