While the outlook for the UK economy remains subdued and dependent on developments on the eurozone, we have a more positive view on UK equities. They benefit from significant exposure to international economies, with global GDP arguably a more important driver of UK equities than UK GDP. Unlike the UK government, many companies

enjoy robust balance sheets and the equity market also tends to exhibit defensive characteristics, which should be supportive in times of economic uncertainty. Valuations are attractive, on a forward earnings ratio of about 8.6 times (compared to a 10-year average of about 14 times) and a dividend yield of about 3.6%. Furthermore, Sterling investors in UK equities would benefit from any depreciation in the currency, which may result from extended quantitative easing by the Bank of England and further weakening in the economic outlook.

Prospects for continental Europe remain dominated by the eurozone debt crisis and the ability of politicians to arrive at a permanent resolution to the problem. European equities trade on a low multiple of 8.8 times forward earnings, implying the asset class offers significant value should a solution be found. However, the debt crisis is already having an impact on the European economy with Purchasing Managers Index (PMI) manufacturing and services indices moving firmly into contraction territory in October. A break-up of the eurozone, which is not our central scenario, would have severe negative implications for the European economy and equities would likely see significant downside in this event. But the effect on individual companies is likely to vary considerably, particularly due to the re-emergence of currency risk and potential balance sheet impacts.

US EQUITIES

The outlook for the US economy remains tough, particularly as unemployment is stubbornly high at about 9%, with consumer spending a key driver of growth. However, the US does appear to be seeing stronger growth than other developed economies. This may provide some support to 2012 corporate earnings, at least compared with other developed markets, especially if economic stimulus measures are extended into 2012. Although valuations are somewhat higher than for other developed markets, with a 2012 forecast price/earnings ratio of 10.9 times, we consider this a fair premium given the stronger economic momentum. Political deadlock has been a severe impediment to the US dealing with its budgetary problems, with the country standing alone among major economies in not enacting fiscal austerity. 2012 sees presidential and congressional elections and we would hope that post the primary stages of the contest, which are likely to see candidates appeal to their narrow party bases, they seek common ground and realistic ways of resolving the long-term budget pressures.

JAPANESE EQUITIES

Japanese equities frequently traded in a disconnected manner from other markets in 2011. Like other equity markets, valuations remain attractive, particularly if Japanese companies can boost their levels of return on equity, although this is likely to be a longer-term development. For 2012, Japanese equities are likely to be affected by the slowdown in global growth, while we would also expect appreciation to dampen corporate performance.

EMERGING MARKET EQUITIES

Powerful longer-term phenomena such as industrialisation and urbanisation, as well as more robust fiscal positions, underpin our positive view on emerging market equities. We continue to see stronger growth from emerging economies compared with developed economies in 2012, albeit at slower rates than previously. Emerging market equities have underperformed developed market equities in 2011. There is some risk that further downward revisions in global growth could lead to them continuing to trade as higher-risk plays rather than reflecting the superior structural features of their economies. However, valuations are attractive with aggregate emerging market equities trading on about 9 times next year’s earnings, against a 10-year average of about 11 times. Eastern European equities are exposed to the risk of a credit crunch as deleveraging banks withdraw credit from the region. Within Eastern Europe, we favour Russian equities, where valuations remain low at about 4.9 times earnings (against a 10-year average of about 8 times). The country is a play on oil and other hard commodities where we have positive views. The outlook for the oil price represents the key risk for the asset class and a more pronounced economic slowdown, which will likely lead to a material fall in the oil price, would be particularly negative for Russian equities. This is not our central scenario. Political risks also remain, particularly in a presidential election year. Latin American equities are also extremely attractively valued on a P/E ratio of 9 times 2012 forward earnings, compared with a five-year average of 11.4 times. Slowing worldwide demand and falling commodity prices have raised fears for Latin America, however, despite this, commodity supplies remain tight overall and, so far, the likelihood of a crash similar to that of 2008/2009 seems low. Should there be a prolonged downturn, the region’s economies have many tools at their disposal to counter this – for example, there is ample room to cut rates if necessary (Brazil has already started this measure). On a macroeconomic level, many Latin American countries in the region are in better shape than their developed market peers, supported by higher levels of consumer confidence and solid fiscal accounts.

ASIA EX JAPAN EQUITIES

The slowdown in global economic activity has had an impact on Asia ex Japan, given its relatively high levels of exports to developed countries. However, we still view the economic backdrop favourably, with its economies offering stronger growth than the developed world. Inflation is showing signs of moderating and we could see loosening monetary policies in 2012, which we would regard as positive for the region’s economies and equity markets. Within Asia ex Japan, we favour Chinese equities where valuations are low in our view, with the market trading on about 8.2 times 2012 earnings, significantly below the market’s 10-year average of about 12.5 times. There are risks in that the rapid rises in residential real estate prices could reverse and become destabilising to parts of the economy, but overall, we forecast a soft rather than a hard landing for the economy and forecast 2102 economic growth of around 8%.

The UK government’s extensive austerity measures have ensured that interest rates have remained low, particularly in comparison with some of the more distressed sovereign bond markets in the eurozone. The UK is increasingly seen as something of a safe haven. Furthermore, as the expected path of inflation has fallen, the Bank of England

has expanded its asset purchase programme. These events have seen government bond (gilt) yields fall to levels we do not believe offer attractive return prospects, particularly given current inflation rates. In the absence of an improvement in the UK’s macroeconomic data, yields may well remain at low levels for some time, although constructive steps to resolve the eurozone sovereign debt crisis could see gilt yields rise and prices fall, as the safe haven premium of the market is reduced.

The outlook for the eurozone economy has significantly deteriorated over the last quarter. Economists are now forecasting a mild technical recession (two consecutive quarters of negative real output growth) in 2012. Countries with high debt and/or budget deficit ratios witnessed their funding cost surging to all-time highs since the euro was launched, with Italian and Spanish yields causing particular concern. Even core economies supposed to be immune to peripheral contagion saw government bond yields rising well above corresponding German benchmark yields. The probability of a eurozone break-up has increased, but although the situation is difficult to predict, we would anticipate politicians will eventually establish a decisive programme to restore market confidence as the collateral damage would be so severe. This may imply a stricter application of a revised Stability Growth Pact over the medium term, opening the way for a more drastic involvement of the European Central Bank in the short term. Overall, we are cautious on the more ‘distressed’ European sovereigns as well as on German Bunds due to the low yields on offer, with a resolution to the eurozone’s problems leaving Germany with additional financial obligations.

US GOVERNMENT BONDS (TREASURIES)

US government bonds yields remain extremely low despite investors losing confidence in the role of political institutions to tackle fundamental budgetary problems. The US Congressional Budget Super Committee failed to reach a bipartisan deficit reduction agreement after three months of intense negotiations, despite a similar political deadlock over the summer leading to the US credit rating being downgraded by one notch by Standard & Poor’s. More positively for treasuries, the Federal Reserve decided to lengthen the average maturity of its treasury holdings by selling USD400bn of short-dated securities and purchasing longer-term bonds. They also committed to keep Fed fund rates low for a longer period of time. Notwithstanding Federal Reserve actions that are currently supporting prices, we remain cautiously negative on US treasuries as an asset class. We believe the positive surprise seen in economic data can continue and should the eurozone reach agreement on a lasting solution to its sovereign debt crisis, the safe haven premium embedded in US treasury prices may start to evaporate. This would force yields to rise to levels more reflective of the current economic and fiscal backdrop.

CORPORATE BONDS

Concerns over the difficulties facing Greece and other troubled European nations, as well as slowing economic momentum, led to corporate bonds underperforming the government bonds in 2011. Financial issues were weaker than non-financial, largely dictated by the extent of their exposure to peripheral Europe. Debt with less priority for repayment within the capital structure – such as Tier 1 instruments – suffered most. Corporate bonds issued by other non-financial sectors also suffered due to contagion effects and an increased expectation that companies will fare less well if the economic backdrop deteriorates. The poor performance of corporate bonds in 2011 has seen yield differentials over the safest sovereign issuers rise to relatively attractive levels, particularly if fears of a double-dip recession are overdone.

EMERGING MARKET BONDS

Emerging market debt markets have seen a transformation over recent years, with countries showing significantly improved fiscal positions and trade balances as well as robust economic growth. Valuations remain reasonable and we see emerging market sovereign bonds outperforming the ‘safe haven’ developed economy bond markets, the latter of which offer very low yields to investors in our view.

We are broadly positive on property as an asset class. It offers an attractive yield uplift over government bonds, which should persist as central banks maintain accommodative monetary policies. Asia Pacific has the strongest fundamentals, although rental growth may moderate should the global economy slow. High levels of US

unemployment and the tough outlook for the European economy are likely to provide a challenging environment for rental growth.

Low interest rates, and the prospects for further central bank intervention in developed economies, have been supportive for gold. We remain alert to the risks that a bubble could be forming in the asset class. The sharp sell-off in September 2011 indicates gold is not necessarily defensive and could see significant downside in the event that

the world’s imbalances are corrected and the uncertainty lifted. This risk and the difficulty in valuing gold makes us wary of holding significant positions over the longer term. However, as it can provide something of a hedge to extreme negative events, we continue to advocate modest holdings in diversified portfolios while the outlook for the global economy remains so uncertain.

We believe hard and soft commodities offer the prospects for attractive longer-term returns, given continued demand growth from emerging markets. This is growing from a low base, and supply remains restricted due to a decline in mining capital expenditure post the 2008 financial crisis. Many commodity markets have seen declines in 2011, as

economic activity has slowed. However, as emerging economies are the key drivers of demand growth and we do not forecast a global recession, we believe the price declines seen in 2011 are corrections rather than the end of positive longer-term trends.

Many currency markets have been driven by similar factors as equities and bonds, such as the Swiss franc, for example, which has seen significant appreciation. We would see a resolution of the eurozone sovereign debt crisis as positive for the euro and negative for the Swiss franc, and possibly the dollar and yen, should such a resolution be

accompanied by a wider increase in risk appetite. Longer term, we see the emerging market currencies as well placed to appreciate, reflecting their long-term structural advantages, although policy actions may slow down the process.