"Outlook for 2012" has been produced by HSBC Global Asset Management to provide a high level overview of the economic outlook and is for information purposes only. The views expressed were held at the time of preparation and are subject to change without notice. It does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as a research report. You should be aware that the value of any investment can go down as well as up and investors may not get back the amount originally invested. Furthermore, any investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in established markets. Any performance information shown refers to the past and should not be seen as an indication of future returns. You should always consider seeking professional advice when thinking about undertaking any form of investment.
Looking past the abyss
- 2011 proved an extremely volatile year, largely due to ongoing uncertainty surrounding the eurozone sovereign debt situation
- Growth has slowed throughout the year, with the International Monetary Fund (IMF) cutting its 2011 Gross Domestic Product (GDP) economic growth forecast for Western economies from 2.5% to 1.6%
- Developed economies – with the US a major exception - are engaged in austerity measures while the emerging world is looking to dampen its much stronger growth to stave off any threat of inflation Read More
- Any improvement next year rests largely on the eurozone finding an appropriate solution to its problems
- Against this background, many investors have fled to what they saw as safe havens, forcing gold prices to record highs and government bonds yields to generational lows
- Short-termism is rife in such volatile markets, creating opportunities in some asset classes for investors who can take a longer-term view
- Equities currently look to offer the best value, with many corporates in solid financial shape after applying their own austerity measures amid the credit crunch. Strong balance sheets are allowing ongoing dividend growth
- Share valuations remain low, reflecting the muted economic outlook in the West. This ignores two key factors: that many Western companies have growing Eastern earnings exposure, and the potential for emerging market equities to benefit from the region's stronger macro outlook
- Core Western government bonds represent poor value, with short-term safe haven investing forcing yields down. In some instances, this asset class currently offers the prospect of negative real returns (returns after adjusting for inflation)
- A combination of more persistent longer term inflation and the industrialisation of emerging markets favours physical assets like property and commodities. A positive supply and demand picture is also supportive for the latter
- Gold has proved popular as a safe haven, but with no yield the precious metal is challenging to value, and is likely to suffer when investors want to move into more risk orientated assets again Back to top
Market review and outlook
Markets looked into the abyss once again in 2011
Having started the year robustly enough, the outlook deteriorated sharply as the year progressed, with investors facing the prospect of recession (and some would argue depression) and even questioning the future of the financial system. Faultlines were evident early on, with civil unrest in the Middle East spreading to Libya and resulting in oil prices rising to a two-and-a-half year high. Japan then Read More
suffered a huge earthquake, tsunami and nuclear incident in March, causing supply chain issues for much of the year.
The real test for investor nerves came over the summer. Fears centred on Europe, with many nations suffering from high sovereign debt to GDP levels, budget deficits and low growth. While this focused on peripheral Europe until the autumn, signs of contagion spread to larger nations such as Italy and Spain as bonds yields rose through 7% and 6% respectively. This in turn put pressure on the banking sector, a significant holder of sovereign debt, and concerns resurfaced that many in Europe would need to recapitalise or accelerate deleveraging (lowering debt levels). Furthermore, as bank funding costs rose, their ability to finance themselves was restricted, preventing them from supplying credit to the real economy. Another challenge faced by markets was one of slowing economic growth. Global growth had been recovering steadily since the end of the recession caused by the 2008 financial crisis (albeit rather unevenly, with muted growth in developed regions and much stronger figures in emerging markets).
Moving through 2011 however, this growth started to fall rapidly. In January, the IMF forecast 2011 GDP growth in advanced economies of 2.5%, but had revised this down to 1.6% by September. Emerging economies continued to benefit from structural growth drivers but were not completely immune from the slowdown in the developed world, having to raise interest rates in their battle against inflation. As a result, the IMF cut its 2011 growth forecast from 6.5% to 6.4%. All in all, the combination of slowing economic growth and fears that the euro and even the European Union may cease to exist in their current forms saw investors flee riskier investment categories such as equities and commodities, as the chart below shows. They looked for solace in traditionally defensive areas such as 'safe haven' government bonds and gold. Unusually high levels of volatility in the value of different types of investments was evident for much of the year.
Performance of major asset classes in 2011
Outlook for 2012
Central to any outlook for 2012 is that European authorities deliver a comprehensive solution to the ongoing eurozone sovereign debt crisis. Officials have been applying a 'sticking plaster' approach to their problems: rather than tackling things early, politicians have only acted when faced with severe market pressure, and only then delivering just enough to stem the tide. This only served to highlight the fundamental inadequacies of the eurozone's structures. Such a too little, too late approach is rarely an answer to market problems – investors invariably move onto the next problem and often, what started as a small issue quickly escalates into something far more serious. The situation in Europe over summer serves as an example. Almost from day one, investors deemed the package to bail out Greece as inadequate. They quickly moved on to attack the systematically far more important Spanish and Italian government bond markets, forcing yields up to unprecedented levels (as the first chart below illustrates). Global economic growth is likely to remain under pressure (as the chart above shows). This is partly due to many developed economies instigating austerity packages and emerging markets stepping on the brakes to slow a growing inflation threat – but Europe is clearly compounding the problem. Despite many European companies being in relatively robust financial positions, they have simply stopped investing, preferring to wait until confidence increases before spending their cash.
The cost of government borrowing increased significantly for Italy and Spain
The growth outlook for developed markets has deteriorated
In the face of such uncertainty, how can investors position a portfolio and even continue to hold more risky asset classes? Perhaps the best answer to this is encapsulated by Warren Buffett, who said 'be fearful when others are greedy and greedy when others are fearful'.Back to top
The shift to short-termism
Underlying these words though is something far more fundamental. In short, markets have gone from being dominated by investors with longer-term investment horizons to being driven by short-termism. To a large degree this is understandable. When volatility is high, as it is now, investors quickly turn from targeting wealth generation to focusing on preserving it. The prospect of seeing hard-earned Read More
capital fall sharply in value is simply too much for many investors to bear. They would rather avoid riskier areas and invest in more conservative asset classes, even if the latter appear expensive in the long term. Compounding this shift to short-term investing though are some deeper, structural trends within world stock markets. Historically, pension funds were classic long-term investors. They had long-term liabilities and needed to invest in assets that could grow to meet these – importantly, short-term volatility was not a major concern and seen as a price worth paying for capital growth. More recently though, there has been a shift in behaviour, (as the chart below illustrates), with many funds now no longer targeting future liabilities but rather focussing on contributions. The need for holding risk asset classes has fallen, with bonds doing the job regardless of whether or not they generate value in the long term.
We see this as a fundamental weakness in how individuals fund their retirement. Further, regulation is such that many funds have been required to sell down their riskier asset classes and switch into bonds. The rise of hedge funds and high frequency investors has exacerbated this problem by accentuating volatility further. Here, though, is the opportunity for investors prepared and able to invest for the longer term; short-termism creates some exceptional investment opportunities.
US institutional investors have become more focused on the short-term
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The case for equities
If you can look through the short-term fog, equities offer some excellent opportunities for building wealth in the longer term, as part of a balanced portfolio. Companies, in contrast to governments and the consumer, have been managing themselves extremely prudently. While the former were building debt to unsustainable levels, companies were paying down borrowing and building cash balances. Read More
Equity dividend yields currently stand at attractive levels, (as the first chart below illustrates), compared with government bonds, while company balance sheets are enabling them to grow dividends – a very attractive combination in a low interest rate environment.
Equity dividend yields are currently at attractive levels
Valuations are also extremely low by past standards (as the chart below illustrates). To some degree, this is justified with growth in developed economies likely to be somewhat lower than it was historically. But focusing on lower growth rates in developed economies ignores two key features. First, companies in developed markets are increasingly global in their outlook. They are not just a play on the economic growth of the country of their domicile, but instead can benefit from higher global growth.
Equity valuations look attractive
Second, emerging market equities themselves offer investors the opportunity to benefit from the positive structural growth trends exhibited by developing economies. That said, performance of many emerging markets in 2011 shows they are not self-sufficient yet, with a high reliance on exports to the developed world. As they continue to grow however, there will inevitably be greater spending on domestic infrastructure (as the chart below illustrates) and an increasingly wealthy population will look to consume more. This will reduce the dependence on exports and with it, make emerging market economies and possibly stock markets increasingly guardians of their own destinies.
Emerging markets future infrastructure requirements are high over the next 25 years
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The case against government bonds
The mirror image of this value in equities is the overvaluation within many government bond markets, with yields in many cases not sufficient enough to cover inflation. Government bonds have not only been one of the main beneficiaries of the shift to short termism, but also the long-term down trend in global inflation and interest rates. Read More
Again, much of this has been driven by emerging markets, which have increasingly become the manufacturing engine of the global economy.
This phenomenon has had two related impacts, with both driving down bond yields. First, by exporting cheaper consumer goods into Western economies, inflation rates have been held down. Second, these exports have created significant current account surpluses within developing markets, which have in many cases been recycled into Western government bonds, further pushing down yields (as the chart below illustrates).
While inflationary pressures look muted in the near-term as austerity packages in the West kick-in, we see the structural downtrend in inflation coming to an end.
Wages in many emerging markets are now rising rapidly as these economies grow richer and their workers demand higher wages. Also, as the global economy rebalances over the long term, the flows into western government bonds of recent years are unlikely to be repeated. Hence bonds have been the beneficiary of an almost perfect storm – a long-term downward shift in yields, accelerated by investors' pursuing safety in the short term. However, surely just as the bond evangelists' calls for structurally lower yields become more vocal, investors with a long-term outlook should be avoiding this category given the prospect of negative real long-term returns.
Government bond yields have fallen dramatically
Commodities and property
A combination of inflation proving increasingly persistent and the industrialisation of emerging markets favours physical assets. Areas of the market such as commodities and property see their values rise with inflation and also benefit from growing demand as emerging markets urbanise. Although many commodities have seen price declines in 2011, reflecting the global slowdown in economic growth, they should benefit longer-term from the seemingly unstoppable pressures of rising demand from infrastructure projects and limited supply in many cases. Prices in the long-term are seeing significant upward pressure. Property yields also often give investors a decent uplift over many government bonds (as the first chart below illustrates), which is an attractive feature for many investors in a low interest rate environment.
Property yields look attractive compared with government bonds
The one exception to this is gold (as the chart below illustrates). To many, this represents the ultimate safe haven investment – it is a physical asset and, much to the unease of many a central banker, you cannot print any more of it. To some extent, we sympathise with this view, with gold typically enhancing portfolio returns at the same time as reducing risks. It does however have one major problem; with no return, you just cannot assign a fundamental value to it. In all probability as an investment it represents the flipside of the coin to investing in risk assets – that is, the more people avoid risk assets, the more they will look to buy gold with their capital. When risky assets turn though, you really do not want to be the last person holding gold.
Gold is seen as a relative safe-haven
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We are keen not to underplay the risks of investing in global stock markets at present. However, the short-term direction is in the hands of politicians.
In the West, politicians are grappling with excess debt, global economic imbalances and perhaps most importantly how to solve the eurozone debt crisis in the face of inadequate governance. Conversely in Asia, central bankers are walking a tightrope of reducing inflation without killing off growth completely. Historically, the Chinese authorities in particular have been successful in achieving this but the risks remain. This makes the short term uncertain, but for those with the luxury of being able to take long-term investment decisions, this increasingly short-term world is creating some rare opportunities to generate wealth. The start point may be uncertain but the eventual upside is potentially significant.
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