Stepping away from the edge

The New Year began with the US congress finally agreeing a last minute deal to avert, or at least delay, the worst of the much discussed “fiscal cliff” of scheduled tax increases and spending cuts. If triggered, these measures, estimated to be worth up to $650bn (€490bn), could have sent the US back into recession, with serious repercussions on the global economy.

The compromise bill raised taxes on upperincome Americans but left a host of issues unresolved. The delayed $110bn in automatic spending cuts, the so-called sequester, will again kick in unless an agreement is achieved before the end of February.

At the same time, the US has again hit its debt ceiling of $16,400bn and will face the need to increase its borrowing limit. Budget deficits are expected to rise by $3,600bn in a decade. Ongoing political battles on spending and the debt ceiling will very likely drive market volatility in the near term, although the markets’ strength indicates that the majority of investors believe a deal will eventually be reached.

“The US still have one foot over the fiscal cliff,” says Robert Farago, head of asset allocation at Schroders Private Banking. “While we do not see growth derailed in 2013, we are far from confident that politicians will do more than kick the can down the road one more time.”

Since mid 2012, US corporates have been holding off investments for lack of visibility on the budget negotiation and the visibility has not improved much at all after the recent agreement, comments Didier Saint Georges, member of the investment committee at French funds house Carmignac Gestion. “The real cliff is only coming now, with a debt ceiling which has already been reached and urgently needs to be negotiated up. Brinkmanship is likely to prevail again, which could delay further corporate confidence,” he says. The US consumer is likely to remain the main, and most fragile, growth engine for the US economy in the short term.

“Policymakers have placed a small plaster on a gaping wound and are hoping growth will solve the problems,” believes Mouhammed Choukeir, CIO at Kleinwort Benson. “This is far from a basis for the comprehensive, long-term deal needed to put the world’s largest economy on the path of sustainable budgets, while not snuffing out a budding recovery.”

PULLING TOGETHER

Bill McQuaker, head of multi-asset at Henderson Global Investors, believes that having got over one of the fiscal hurdles indicates there is willingness on both sides of the House to get through this period without risking a new recession and therefore there is more optimism that subsequent hurdles will be cleared.

The US deal on the fiscal cliff, or expectations on its result, triggered private banks and asset managers to make changes to portfolios. In the US, Wells Fargo Private Bank implemented a tactical shift in its clients’ asset allocation, moving 5 per cent out of fixed income into equities, just after the compromise was struck. The bank increased exposure to US large caps and emerging markets stocks, on both of which it is currently overweight.

Both the fiscal cliff compromise and December minutes of the Fed, indicating several members want the US central bank to stop or slow down its bond-buying programme well before the end of 2013, were positive for attractively valued equities and negative for the bond market, where interest rates are artificially low with a lot of pressure to go higher, explains Ron Florance, managing director of investment strategy at the US bank.

US large caps stocks are favoured over small caps because of attractive valuations and earnings and also because of their greater global reach and access to the growing global middle class consumer. “Roughly 1bn people are expected to join the global middle class over the next decade and an additional 3bn over the next 20 years; an economic force which needs to be paid attention to in portfolios,” says Mr Florance.

In Europe, the expectation of a last minute deal in the US led UBS Wealth Management to keep a moderate risk-on position in clients’ portfolios to the end of 2012. This was achieved through high yield, and to some extent investment grade bonds, says Mark Haefele, head of investment at UBS WM in Switzerland.

“After the agreement, we reduced the overweight in high yield bonds slightly and moved that part of our risk budget into equity,” he explains. The result was a modest risk increase. “Some resolution of the fiscal cliff was one final hurdle that we wanted to see before we upgraded to equity.”

The fiscal cliff was a political event that “could have seriously derailed the stronger economic growth seen over the past few months” and is likely to carry on. The eurozone is expected to come out of recession this year and positive signals are coming from China too, says Mr Haefele.

In moderate European portfolios, UBS holds 4 per cent overweight in high yield positions and 2 per cent overweight in equity. “We need to see stronger growth both globally and the US, risk premia fall and increase in earnings momentum before we can make more of a shift into equities,” he says.

UBS is overweight the US and emerging markets equity. Growth is expected to accelerate this year in emerging markets. They are less expensive than elsewhere, and “inflation is relatively in check”, unlike in 2011.

European stocks valuations, measured by their price to earnings ratios, look attractive, and the economy is stabilising, but the earnings estimates are still probably too high, believes Mr Haefele. “European equities are not as cheap as people think and they may be subject to some disappointment.”

ACROSS THE POND

European equities will offer better value than US stocks this year, believes Manuela D’Onofrio, head of global investment strategy at UniCredit Private Banking. European equities are trading at a discount to US equities which is the biggest of the past 20 years, she says.

Reform programmes implemented in the peripheral countries, expected to give much higher emphasis to GDP growth this year, combined with a sensible reduction of the risk of a eurozone break-up will drive a fall in the risk premia of European equities, says Ms D’Onofrio.

The catalyst that drove a big change in the asset allocation strategy at the pan-European bank was Mario Draghi’s speech announcing the OMT programme last summer, which represented a turning point in the eurozone crisis, clearly showing Germany’s desire for a higher level of eurozone integration.

Since 2009, says Ms D’Onofrio, the bank’s strategy has been based on the very strong belief that the euro would not break-up and on a very positive view for credit risk, including corporate investment grade and high yield bonds as well as emerging market debt. “For the first time in four years, last September we took the decision to increase our exposure to equity, in particular European equity, as we see more value in equities than in corporate investment grade bonds.”

The bank has consequently moved from a neutral to overweight position in equity, which was financed by taking profit on investment grade corporate bonds.

Also, while in the past four years the bank kept an “important overweight” in US stocks and underweight in European equities, in order to contain volatility in portfolios, in 2012 it increased exposure to European equities as they are expected to further gain ground in 2013, thanks to a gradual return to “normality” after 18 months when markets believed a euro break-up was very likely.

A positive surprise could come from Italy this year, says Ms D’Onofrio. “If the new Italian government continues with the reforms programme outlined by the technocrat government, there will be margin for recovery for the Italian equity market.”

In addition to Mr Draghi’s speech last summer, an upswing observed in real money supply indicating an improving economy, and stabilisation from the OECD system of composite leading indicators, designed to provide early signals of turning points in business cycles, led to a change in the asset allocation in the multiasset portfolio, says Henderson’s Mr McQuaker.

“Those events encouraged us to take a more pro-cyclical, pro-financial market risk position in portfolios. We have increased exposure to Europe and to Asia, while we maintained our positive view on Japan,” he says.

The monitoring process is now focusing on deciding whether the incoming data is consistent with the view that is already embedded in portfolios. “So far it has fitted with the pattern that we expected to see unfold.”

The next question is to judge when financial markets have moved far enough that this improvement has effectively been priced in and when and if to take some profits in Europe and Asia, he says. For example, even slightly higher US GDP growth than the consensus of 2-2.5 per cent for this year would result in some kind of global growth surprise and more risk-friendly financial markets. “And the biggest beneficiaries in terms of stock prices would be probably outside the US, as the US stock market is quite highly rated and valued already.”

However, it would be wrong to completely downplay the risks the world still faces. US politicians are likely “to muddle through the next set of fiscal discussions”, but that needs monitoring. In Europe, elections coming up in Italy at the end of February also need to be watched closely, he says, wishing the new Italian government was “some version of the status quo, reform-minded,” and which had “in an unofficial sense the tacit approval of Germany and the ECB.”

THREAT OF INFLATION

Central banks have been aggressive in supporting economies through quantitative easing programmes, but inflation could become a concern, as velocity of money increases.

“We are very worried about inflation. Our long-term capital market assumption for inflation is 3 per cent and at that level you lose half of your money in 25 years,” says Wells Fargo’s Mr Florance. His key recommendations are to keep bond duration short, invest in global equities with exposure to the growth of the global economy and in real assets such as real estate and commodities.

An acceleration of economic activity would change the outlook for monetary policy in most parts of the world too. A rise in interest rates would be detrimental in particular for bond prices. The assets that were perceived as the safest could turn out to be the riskiest.

“For a generation, people perceived the safest asset class in the world was a 10-year Treasury bond. We actually think that’s one of the most risky asset to invest in right now,” says Mr Florance.

Lower bond yields, on one hand, and an improvement of economic and political fundamentals, on the other, are leading private banks to recommend their clients start moving away from bonds into equities or at least direct new cash into equities rather than bonds.

“A beginning of an unwinding of bond allocation and of an increasing allocation to equities” characterises the portfolio strategy at Deutsche Bank PWM, explains Paul Wharton, chief UK investment strategist.

Credit spreads are coming in sharply, as this dash for for income, evident among private clients, has driven nominal yields down. A high yield bond that used to yield 8-9-10 per cent is now yielding 4-5 or 6 per cent.

“There has been a big dash for income in less good quality assets, but when the economy turns and the penny drops, some of these risks begin to become more apparent. Then there will be a wholesale dash out of that particular market place. Liquidity in bonds can dry out more quickly than people often realise, particularly in the high yield space. High yield bonds are still junk bonds,” says Mr Wharton.

Coupon is the only return investors are going to get from fixed income this year and there is real risk of capital losses, he says. “Clients need to be very careful where they are both in terms of credit and in terms of where they are on the yield curve, because right now markets, including equity markets, are beginning to discount a stronger economic environment going into this year.”

This is proved by 10 year bond yields starting to rise. For example the 10 year UK gilt, which was 1.70 three months ago, has risen to more than 2 per cent today.

“In 2012 and continuing in 2013, we have seen our clients really placing a premium on liquidity and safety, which they have expressed through large overweights in cash and government bonds,” says UBS’s Mr Haefele. But government bond holdings are likely to provide negative real yields going forward.

“We are encouraging clients to begin to make a shift away from in particular government bonds and towards either investment grade bonds, or high yield bonds or into equities,” he says.

While last year was an outstanding year, low single digit returns are very likely for investment grade bonds in 2013, he says. High yield bonds are still seen as very attractive asset class on a risk adjusted basis, with mid single digit returns expected over the next six months.

To encourage clients to make a gradual rotation into equities, UBS “places a premium” on companies that pay dividend based on strong free cash flow. In many cases dividend yields are higher than the return on government or corporate bonds, helping make the shift into equities a little easier even for clients that rely on some investment income, explains Mr Haefele.

In addition to implementing a strategic and tactical asset allocation, it is important to identify themes that resonate with investors. One of UBS’ investment themes, also popular with other private banks, is “Western winners from emerging market growth”, ie companies trading on European exchanges deriving a significant portion of revenues from consumer or luxury markets in emerging markets.

In fixed income, investing in developed market Asian banks is also seen as an attractive theme. A number of top Asian banks, primarily in Hong Kong, Singapore and South Korea, are expected to have attractive yield pick up in their bonds. These banks have stronger balance sheets, were less exposed to the financial crisis and are not being forced to face the same regulatory requirements as many banks in other parts of the world.

Deutsche Bank PWM believes that in 2013 it will be important to identify “real growth, driven by sustainable trends” in those sectors that are not being temporarily and artificially boosted by government intervention.

These include technology, which is mainly a US story. Spending on this sector is likely to continue from governments, corporates and consumers. On an absolute and relative basis, technology continues to be the most attractively valued sector in the US. Healthcare is also seen as another sector that will be able to escape the impact of government austerity in the developed markets. Increasing wealth, aging populations and in some countries, such as China, the explicit desire to increase healthcare spending to tackle social issues, will lead to higher healthcare expenditure.

Giles Keating, Credit suisse

In the equity space, Credit Suisse puts an emphasis on the “recovery stocks” theme, aimed at identifying cyclical stocks that benefit from economic recovery in the US, Europe and Asia. For example, in the US some opportunities are found in the industrial and commercial real estate market, explains Giles Keating, global head of research for private banking and wealth management at Credit Suisse.

In Europe, the recovery theme can be played by European banking stocks or other stocks in peripheral European markets. “Some of the best performing markets last year were in the eurozone periphery,” he explains. “Markets like Spain and Italy have been sold so heavily by nervous investors. When the disaster did not occur these markets improved, but they are still trading on lower valuation than many other markets. We think there is still some scope for growth there.” Stocks in Asia Pacific that can benefit from this recovery include discretionary consumer spending stocks, or even banks.

Another theme is that of equities benefiting from the current and ongoing high level of oil prices. Driven by high demand for oil in Asia and other emerging markets, Brent crude oil prices have reached $110/$115 a barrel, which is triple what they were over the 20 year period ending five years ago, making a lot of unconventional and difficult oil sources potentially possible, says Mr Keating. These include exploration in Arctic waters or deep water drilling and the shale gas boom in the US is potentially spreading to other countries, including the UK. These energy sources open up new investment opportunities, including not just the companies involved in oil exploration but also those involved in the provision of the equipment for oil and gas exploration.

THE RULE OF POLITICS

Since the global financial crisis, macro-economics and political developments have heavily affected capital markets, increasing market volatility. This is expected to carry on this year.

“Politics and governments are going to continue to have major influence on markets and investing. That’s the new reality that investment teams need to develop expertise in, if they want to outperform,” says UBS’ Mr Haefele.

Fundamentals always rule, believes Wells Fargo’s Mr Florance. “We try and manage volatility through asset allocation, diversification and rebalancing and not trying to time the market through media hysteria around political headlines. In 2012, there were so many instances where the world was going to come to an end. And now you can wait until the debt ceiling discussion, and then you can wait and see if Berlusconi is going to come back and run Italy. In the meantime the global economy is recovering, global consumers are growing in numbers and in economic influence. If you wait for perfect clarity, you are going to wait for a really long time.”