Investors returned to their desks in the new year seemingly intent on extending the party mood into 2013.
By averting the immediate danger of plunging over the fiscal cliff, US politicians have not called time on the positive returns generated in 2012 and have given markets some further good news to toast. We’re happy to join in the revelry, but see a number of challenges ahead in 2013.
The good news is that the political uncertainty that has weighed on market sentiment is lifting. We believe we are at ‘the end of the beginning’ of the European crisis, with investors now clear who is in charge and how they will react to risks to the system. We know we are in the hands of the Germans, who want deeper union and, based on Mario Draghi’s comments, that the European Central Bank is willing to step in as required.
In addition, the Chinese political transition has occurred as planned and the new US government has been chosen. We’re still hostage to political brinkmanship in an environment where the direction of fiscal policy is crucial, but political risk is a little easier to understand as we enter the new year.
The bad news is that the cyclical environment remains challenging. A typical catalyst for a sustained improvement in the outlook for risk assets – signs of an upturn in the economic cycle – is absent.
We expect a continuation of low interest rates and anaemic growth in 2013, with central banks’ willingness to keep rates low and accept inflation to curb unemployment, countered by the impact of tighter fiscal policy and further deleveraging. In this context, quantitative easing (QE), by itself, does not justify an aggressive stance.
In the absence of economic triggers, we see valuation as the primary weapon in our decision-making armoury this year. Safety is now looking expensive and with negative real yields on cash and bonds, the incentive to take risk is increased.
Endless QE makes cash our least favoured asset class and bonds merit inclusion in portfolios only for their diversifying characteristics. Significant exposure to equities is rational in this context.
Within equities, we continue to emphasise quality, but will look to tactically take advantage of pockets of value where they exist.
Opportunities to buy Europe and Japan presented themselves last year and it will be important to remain on the lookout for similar opportunities this year. In this regard, US domestic growth stories are currently piquing our interest.
Finally, as the valuations of traditional safe-haven assets, such as investment grade bonds and gold, have been pushed to dangerous levels, other diversifying investments should be sought to dampen the volatility that comes with a higher equity allocation.
Volatility-based strategies and macro hedge funds are interesting in this respect, although it is important to understand the cost of owning assets that ‘hedge’ and be comfortable paying over the associated insurance premium during benign periods.