China's affluent young (© Bruno Barbey/Magnum Photos)
Against many confident forecasts to the contrary, the euro did not break up in 2012. This defied the logic that default, leading to exit and devaluation, were imminent for some of the weakest members of a very damaged “club.” The survival of the euro clearly illustrates the extent to which politicians and central banks hold sway over global economic prospects.
Though economic signals can be distorted for a while by the promise of a treaty, or a political fix to avoid a cliff edge, or another crank of the printing press, it is important to retain focus on the economic and investment fundamentals that will eventually come to the fore.
Valuation and understanding the economic cycle are key characteristics of successful investing. But it is sometimes challenging to stay anchored to these relatively simple principles. We don’t have to delve far in our memories to recall the technology boom and bust, or Gordon Brown declaring that he had ended the business cycle.
Encouragingly, the two economies that really drive global growth—the US and China—are both showing some signs of traction. The US housing market has stabilised after a savage correction over the past four years. There is abundant cheap gas from the resurgent energy sector and this will be a boon longer term for the competitiveness of US manufacturing. A key signal that would reinforce confidence in sustained growth will be a pick-up in private sector investment early in 2013. The new Chinese leadership is successfully pulling the levers of central control, avoiding a hard landing and achieving some rise in consumption. It is hard to underestimate the importance of momentum from these locomotives of global growth for 2013: monetary levers, both conventional and unconventional, are looking increasingly exhausted. Even central banks are now talking about targeting growth and employment rather than inflation. This is a significant shift in their priorities that reflects both the importance of growth, as well as its current fragility.
Against this backdrop of nascent growth, it is startling to look at the current valuation of many sovereign bonds, the US and UK both being good examples. After four years of stellar performance, bonds pay out a negative real yield, and should no longer be viewed as low-risk investments for wealth preservation.
Increased confidence in growth, albeit modest, and less attention to inflation fighting on the part of central banks, gives good reason for bond yields to start to normalise at some point this year. There are few western governments that are not wrestling with a challenging fiscal deficit, so a central bank accommodating a rise in inflation will hardly be opposed by politicians (Germany of course being an exception). Inflation is the debtor’s friend and the lender’s enemy and this will not be overlooked by activist lenders, so-called “bond vigilantes.”
We believe bond holders will not be able to rely on capital gains to drive returns, as they have done in recent years and must look increasingly to income. We highlight generous yields that can still be found, but investors will have to take on more risk to access them. Bond investors hoping for a repeat of the stellar performance from European bonds over the past year will probably be disappointed, but swings between confidence and despair over the sustainability of the eurozone should present tactical opportunities. We also think the time is right for investing in bricks and mortar; the US housing market is showing definite signs of a comeback, and there is opportunity in UK commercial property as well.
Increased confidence in growth, and greater danger in bonds, should justify a more sustained flow of investment into equities. There are the attractions of yield, valuation, and the stock-specific opportunities that come with growth. Even in moribund Europe there are high-quality companies able to take advantage of export opportunities to the growing economies of Asia.
But wealth management is less about binary decisions—buy or sell—and more about weighing probabilities across a range of possible outcomes, hence the title of Coutts’s Outlook 2013, “5 Risks & 10 Opportunities.” A key anchor in portfolio construction should always be diversification, ensuring that a portfolio has “ballast” against risk, for example by including investments in gold or property. It may be more interesting to talk about prospective opportunities, but it is more prudent to also talk about managing risk. And in 2013, a long-term investor should be very alert to the trend in inflation.
The impact of politics on financial markets has grown in the wake of the crisis and is a frequent source of market volatility. There is no reason to think that 2013 will not have its fair share of cliff edges, emergency summits and make-or-break elections, some of which will have the potential to substantially change the course of travel. So while we ended 2012 with a relatively strong equity rally and the prospect of a more benign environment for risk assets in 2013, it is not going to be a smooth ride.
