Time to pick equities over bonds

Looking back on 2011, you can’t help but feel a degree of relief. Guarded optimism at the start of the year faded relatively quickly and, for most of the time managers were very much in defensive mode. World equity markets fell 5 per cent in local currency terms, but it could have been far worse.

Investors entered 2011 having enjoyed a strong final quarter of 2010 and were hopeful that the two large systemic risks worrying investors would begin to fade as the year progressed. With no resolution to the problems in the eurozone, we all expected the authorities to do everything they could to prevent a disorderly climax to the debt crisis, effectively “kicking the can down the road” until consensus could be reached or sufficient provisions made to lessen the eventual impact.

In the US, economic indicators were beginning to suggest a fragile economic recovery following massive financial stimulus. Talk of a debt-fuelled recession was giving way to cautious optimism. It was hoped that as these two dark clouds lifted, equity markets could continue to build on their recent progress.

In the event, economic growth in the US began to falter and there were increasing concerns that equity markets were looking fully valued. This caution proved well timed and the correction, when it came in July, was sharp, with the S&P 500 falling approximately 16 per cent and most other world markets experiencing larger declines.

The debt problems in Europe rose to the surface again, and the mood quickly changed as the storm clouds descended. However, in the final three months of the year brighter economic indicators in the US once again began to show through. With the European debt can kicked down the road once again, markets enjoyed a year-end rally.

We seem to have entered 2012 with much the same conditions as we entered 2011 and it would not be surprising if the year unfolded in much the same way. Markets will rally when the economic news becomes less bleak, rather than good, but will be subject to sharp corrections as concerns about debt or growth come to the fore.

It is suspected that the various disaster scenarios will be avoided, but the consensus is that in such times extreme outcomes are more likely, and so we should not be complacent. These conditions may well be with us for many years, as it should be noted that the painful process of debt reduction has barely begun in Europe, and the US continues to increase its liabilities at an alarming rate.

The breadth and depth of the debt crisis and the effects it will have on financial markets have been well reported. It is expected there will be a long period of dull economics as governments and consumers try to reduce their liabilities. In most developed economies spending from these two groups accounts for more than 80 per cent of gross domestic product (GDP), representing a significant drag on economic activity.