"Looking back on 2012, it would be fair to say that given the difficult macro backdrop and the many challenges facing the developed world, risk assets performed much better than many commentators had expected. Within equities, most markets gave comfortable double digit returns despite modestly weakening corporate profits, and negative revisions to GDP growth. Within fixed income, credit and emerging market debt performed well, with returns positively correlated with the riskiness of the investment. Only core Government bond markets gave a disappointing return, but then given the starting yield that was always going to be the case. As we have discussed many times, there were two key drivers to this outcome: In a low interest rate environment, income starved investors were forced to seek out alternative yielding assets and became increasingly more adventurous in the types of investments they considered. The central banks’ various QE policies both crowded out investors, exacerbating this trend, and provided a favourable liquidity backdrop to the market and saw all credit spreads narrow significantly. The second driver was the very robust performance of corporate balance sheets. Companies are at a multiyear high in terms of their financial strength, with record profit margins and prodigious cash flow. As a result the risk of default or bankruptcy, despite the challenging macro backdrop, was deemed low. Investors therefore became increasingly confident of the safety of both their dividends and corporate bond coupons, and rerated asset classes accordingly. This also acted as a catalyst to corporate treasurers to kick-start the bond issuance pipeline and take advantage of the falling cost of corporate debt, even if the cash was used for nothing more than share buy-backs (which in itself was value accretive).
“This all begs the question as to how 2013 might turn out given how well markets have performed over the last 12 months. It is our view that we should still have a satisfactory year. The defining feature is still going to be the zero interest rate environment. Developed world growth is still low by historic standards, western economies are over indebted and the financial system is undercapitalised: Interest rates aren’t going up any time soon. This will continue to force investors to seek out yielding assets and will provide markets with the support it provided last year. However, in our view things are getting a little better: In China we have seen the leadership transition and the end of the accompanying uncertainty has been a boost for both growth and the Chinese stockmarket. In the US, it remains our view that, although it is not yet resolved, a compromise will be reached on the fiscal cliff and this too should provide a boost to growth. In any event, the US housing market continues to recover from very low levels which is supportive of the US banking sector and consumer sentiment. In Europe (both UK and continental), while we are likely to be in mild recession this year, the situation does not appear to be getting any worse and it is probable that the worst of the problems of the banking system are behind us.
“Against this backdrop, it is no surprise that markets have had such a positive start to the year, and it may well be that some profit-taking is in order. Nevertheless, we retain our overweight position to risk assets and expect equities in particular to make further positive progress in 2013. On a number of metrics, valuations are still supportive, and at some stage the M&A cycle will pick up as companies put their cash to work constructively. Our stance is therefore predicated on a safe middle ground- some growth so that economies can continue to rebuild and repair the damage done by the global financial crisis, but not too much growth so that rates remain low. For now we appear on track, but we will clearly monitor developments very closely."