2011 began with promise and ended verging on despair. The consensus coming into last year was for stronger growth, an end to quantitative easing and a rise in inflation and interest rates. Almost a year on the consensus outlook is very gloomy; a global recession (risk of depression), never ending monetary support and an imminent collapse of the Euro zone. There is undoubtedly a crisis of confidence with its roots in Europe’s toxic sovereign debt and banking system which seems to have created a political and policy paralysis. Is there a way out or will 2012 portend the start of an economic demise?

There are critical weeks and months ahead that will shape the economic fortunes for a generation and there is now little room for a slip-up. Financial markets want an instant fix when what is required is a long-term solution, they are behaving like voracious beasts on a feeding frenzy, devouring the PIIGS and moving onto the core German centric markets. The politicians need to calm them with long-term deliverable strategies.

Eventually politicians will take control but the cost to the economy in Europe will be significant and the risk to the rest of world will mount. 2012 will begin shrouded in uncertainties and difficulties, with portfolios reflecting this nervous backdrop. However, greater obstacles have been overcome in the past. The largest economy, the US is growing and emerging markets (although slowing) have the wherewithal to act as a support.

Macro Outlook

The economic outlook has deteriorated as confidence has been hit hard bringing into the spotlight the prospect of a recession in the developed world and a significant slow-down in the emerging world. Will 2012 be the year of despair or the year when policymakers finally take a firm hold and start re-invigorating the global economy?

The IMF has dramatically issued a warning of a 1930s’ style depression having done the opposite 12-months ago when it issued the green light for sustained strong growth. Our view has been that neither the gloomy or rosy scenarios would persist as the reality of a prolonged period of Japanese style sluggish growth in the OECD block would finally prevail. In broad terms, we expect activity in Europe including the UK to contract and in most likelihood deteriorate further in coming months.

The US is growing and is expected to record growth of between 1.5-2.5%. The Emerging Markets as a whole will also moderate and grow by just between 4.5-6% but with huge variances. Emerging Europe is at a significant risk of a recession due to the problems in the Euro Zone with Asia the strongest of this group.

The US economy will be supported by the housing market bottoming (so not acting as a drag on the broader economy), continued moderate expansion in consumer spending and slightly higher capital expenditure. The banks are also in a far stronger position than their European counterparts albeit also contracting their balance sheets. Monetary and fiscal policies will also be used proactively. The political backdrop is messy but should not be a hurdle to mild expansion. Unemployment will remain high and inflation is likely to undershoot.

Europe is in turmoil. The Euro zone is unlikely to escape a recession even though Germany is likely to display strength due to its robust economic structure. The credit crunch stemming from the banking sector will be acute not just for the Euro Zone but for emerging Europe as well. The peripherals and France will likely be in recession in the first half of the year. The UK has self inflicted a recession with austerity for many years ahead. At the same time banks and the private sector will be contracting their balance sheets. To offset this the Bank of England is expected to significantly increase asset purchases but fiscal support is unlikely.

Leading emerging economies will react to slowing economic growth and abating inflationary pressures as they have room for manoeuvre on both monetary and fiscal policies. In terms of monetary policy, interest rates can be easily cut as can bank reserve requirements to ease credit conditions. Fiscal policy may also be used in a more proactive fashion. New growth plans from China and India have historically targeted long-term infra-structure spending as an effective tool to support growth.

There are of course a number of challenges that will raise the spectre of recession. Foremost is the continuing Euro debt crisis, the resultant risk of sovereign and banking defaults and ultimately a disorderly breakup of the Euro. Such an outcome would be disastrous and would hit the US and EM as well. The story is well known – a fractured and poorly designed Euro monetary framework under the auspices’ of Germany, that itself shows little appetite to write a blank cheque for the profligate member states. The ECB has failed to fully participate even though it has introduced some supportive measures. The politicians are moving snail like seemingly unable to grasp the gravity of the situation and if anything exacerbating it by sending out conflicting messages. The German Chancellor is of course right when stating that there are no quick fixes and that the Euro will require a decade to resolve the problems.

For investors this is a dangerous and tortuous period fraught with uncertainty. There have been positive steps and in most likelihood we will get to the brink at which point Germany will finally receive the assurances it requires for a concrete move towards political and fiscal union. A final workable solution will need to be multi-faceted encompassing many of these features (some are already in place):

• Action by monetary authorities to support sovereign debt thereby calming market volatility.

• Unlimited liquidity provision. This is now in place meaning that banks have full recourse to dollar funding.

• Outright sovereign debt purchases (quantitative easing) by all major central banks which may well extend to the Fed also buying Euro debt.

• A re-opening of the primary capital markets to restore confidence.

• Legal changes to European treaties setting the framework for fiscal and political union.

• A beefed up IMF in the vanguard for major emerging markets to re-channel burgeoning reserves.

• The already announced re-capitalisation plan for the banking system, significantly increasing capital buffers. This may even include governments injecting capital.

 

We cannot escape the simple fact that all of the key economic players (consumers, companies, banks and governments) are deleveraging simultaneously. The banking sector deleveraging is extremely important as this will continue irrespective of a Euro resolution. The regulatory regime with Basel 3 and independent moves, such as the Volcker plan in the US and Vickers Commission in the UK, all point to a very different financial landscape. This re-invention will shrink the bank’s balance sheets and as a direct result restrain economic activity. However, this adjustment is necessary as this will reduce the longer-term threats. The pain of transforming the banking sector into utility type entities is exceptional and would have been smoother in a calmer economic phase.

We will begin 2012 with despair and likely end with far more hope as the leading players take control because they understand that failure to do so risks what the IMF warns of, a 1930s’ style depression.

Asset Markets

The last few months have been difficult for all risk assets. Volatility has spiked and is showing signs of remaining at elevated levels. Correlation has also increased dramatically. Many assets such as equities, financial bonds, higher yielding corporate bonds and emerging markets are in negative territory for the year. Commodity markets have also turned sour, with even gold suffering significant falls recently. There has been a flight to quality, with government bond yields hitting historic lows.

In such turbulence it is important that portfolio construction pays heed to the growing risks. Strategically the portfolios have become risk averse and cash balances will be higher than normal in the early months of the year and in the case of the two major asset markets: Fixed Income and equities the focus in the first quarter will be on flight to quality assets. Tactically more aggressive strategies may be deployed for short-term periods to capture any opportunities that arise.

In fixed income the focus will be on the flight to quality assets (G3 government bonds and highly rated corporate bonds). The strategic allocation to systemically important financial institutions will continue but with a smaller exposure to emerging markets and high yield companies. However, this strategic view will change as supportive measures are put in place. In equities, the focus will be on high dividend payers and mega caps that are natural beneficiaries of the flight to quality. The choice of these companies has been expanded to include some of the major emerging market companies as well providing even greater room for diversification.

Equities

Global equities suffered significant falls over the past year as markets were buffeted by the Euro Zone and fears of recession. Although the sell-off has been broad-based, financials have been at the forefront. The way ahead still looks choppy as it does for global economy. In our approach we examine key parameters in order to manage our exposure to equities:

• Absolute and relative valuations to government bonds. These currently look extremely attractive but the enthusiasm needs to be tempered somewhat. Nevertheless for some sectors this will be an important feature.

• Earnings growth expectations have been tempered in recent months and will most likely be lowered even further by previously over optimistic analysts. Market derived expectations are probably more realistic now and provide room for some optimism.

• The cost of capital – “the discount factor” – has been lowered and is also a positive.

• Emerging market growth has slowed but still remains a key area of longer-term prosperity. Multinationals with the ability to access earnings in this region remain of critical importance.

 

Our more conservative approach towards equities will be retained, focusing on high free cash flow and dividend companies with high cash balances and low debt levels. This approach is also inherently defensive due to its exposure to pharma and non-cyclical staples.

Fixed Income

Government Bonds

The major government bond markets (G3 plus the UK and Canada) have been major beneficiaries of the flight to quality, with bond yields at historic lows but volatility has risen even for these markets. They will continue to benefit from a period of sluggish growth, low inflation, low interest rates and central bank asset purchases. Additionally, investor flows will be a major supportive factor. A re-run of Japanese style yield levels is on the cards.

However, many of the peripheral and some core European markets have been hit hard with the cost of capital rising significantly. These markets will be exceptionally volatile reflecting credit downgrades, lack of market liquidity and significant redemptions. A re-opening of the capital markets is necessary to reduce the risk premia attached to these markets.

Corporate Credit

Corporate bonds were mixed in 2011, with European markets suffering steep declines whereas the US market was more resilient. This split is likely to continue in the early part of 2012. US high yield will also remain well supported. Markets have been illiquid at times as new issues have been moribund adding to general worries. Governments will be keen to restore confidence and liquidity.

Our allocation is driven by fundamental due diligence where we focus on the resilience of the balance sheet and the ability of the companies to withstand a slow-down. As part of this process we examine the:

• Debt and leverage ratios. These have been reduced through significant refinancing, cost reductions, increase in free cash flow helped by record low interest rates.

• Default rates. Although at historic lows there is a risk that for cyclical sectors and for those companies still heavily reliant on banks this could turn higher.

• The outlook for the corporate sector will turn a lot more pessimistic if politicians fail to soothe the markets and support the economies.

 

Financials

Financial bonds have been a major allocation over the past couple of years benefiting initially from economic recovery and the regulatory environment. There are many challenges ahead and our strategic view is that the focus must remain on systemically important institutions, with little or no peripheral Euro sovereign debt exposure. The call features remain important, as banks continue to call even during the turbulent periods and the regulatory environment is also evolving in a supportive manner. The basic principle of deleveraging, lower return on equity, and de-risking continues in the background and is positive. However, volatility remains high.

Emerging Market Bonds

EM bonds saw outflows in the final quarter of the year and steep declines in prices as the flight from risk took hold. This partially reflected the greater liquidity in these markets and the need for investors to raise cash after a difficult year. We focus on a number of parameters that remain supportive including growth prospects, balance sheet resilience, debt levels and free cash flow. The need to re-finance through issuing bonds is also extremely low so that credit upgrades will continue for many countries and companies.

Local currency bonds have also fallen sharply as a direct result of the flight to the US dollar and a deliberate policy on the part of some EM central banks to devalue currencies through intervention. EM local currency exposure should be considered in a medium-term context with a diversified allocation across a number of currencies.

Alternative Assets

Hedge funds have been caught up in the market turmoil and volatility. Some managers have been taking advantage of opportunities in the credit, equity, commodity and interest rate markets with positive outcomes. In theory, volatility spikes provide a fertile backdrop but it is a difficult environment and many managers have themselves been forced into a more defensive posture. Certain strategies have benefited, for example, macro strategies. However, managers are also keeping some degree of hedges in their portfolios in order to balance and protect against market corrections. We favour liquid equity long-short managers who have the ability to be very flexible in the management of their net exposures, as well as macro trading managers able to profit from global imbalances.

Real Estate

The combination of an increase in yields and a relatively stable currency is starting to attract foreign investors into the UK commercial property market. Rental levels are mixed, with certain areas proving attractive. The attitude of banks to lending remains a major concern, with deleveraging continuing. Investors are selectively returning to the market. It is important to remember that commercial real estate works in long cycles and this particular cycle has to be put into the context of lower credit availability. The global picture is mixed with further downside likely in the US but with opportunities presenting themselves in Asia.

Commodities

Broad commodities have had a tough year with significant volatility. This reflects the worsening economic prospects across the major economies and the tightening of policy in emerging markets. However, there were pockets of strength particularly precious metals and sporadically oil.

The outlook for the year ahead will be mixed. Economically sensitive sectors will yet again struggle as the outlook is for sluggish growth and recession in certain regions. Gold has generally acted as a safe haven asset, despite the recent correction. As monetary policy becomes more simulative the background remains supportive of gold as a safe haven. Commodities remain an attractive asset class but investors should bear in mind that volatility can be higher than other traditional asset classes.

Summary

The economic environment is the most challenging for a generation and even more so than during the financial crisis as sovereign and banking solvency has come under scrutiny. The situation has been exacerbated by a lack of political leadership both in the US and in the Euro region. The risk of a break-up of the Euro has been more than just a topic of idle chit-chat.

There are no easy solutions to the problems that are now being faced. We have attempted to continue to highlight the likelihood of a prolonged adjustment process similar to Japan. In the developed world we will have a prolonged multi-year period of low growth coupled with low inflation and supportive monetary policy. The Euro zone and emerging Europe will be the clear laggards as they wrestle with the debt crisis. Emerging markets will not escape the back draft from the developed world but have intrinsic strengths and room for manoeuvre.

The early part of 2012 will require an extremely conservative approach as politicians’ inch towards a resolution. It is important that the broader context is kept in mind and portfolio construction allows investors to take advantage of short-term opportunities whilst keeping an eye on the prize – generating income in a volatile world.