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December 2012 Outlook 2013: Opportunities on the bumpy road to recovery

Financial markets will continue to be affected by macroeconomic uncertainties in 2013, but some of the extreme outcomes that investors feared in 2012 are now less of a concern than they were a year ago.

Interest rates will remain low indefinitely and the search for yield will continue. However, fixed income investors should not expect a re-run of the easy ride they had in 2012 – active management will play an important role in 2013 given the strong returns from many fixed income assets over the past 12 months.

In a low growth world, we expect strong companies to get stronger. Businesses that can deliver sustainable growth should be able to command premium valuations, given that overall rates of economic growth will remain subdued. Government balance sheets are likely to remain under pressure, and investors will continue to question the sustainability of AAA sovereign credit ratings in the developed world.

The past year has been another challenging period for many investors due to ongoing economic problems in the developed world, although positive returns from global equities and corporate credit over 2012 to date remind us once more that there is no strongly positive correlation between the returns from risk assets and GDP growth, at least not in the short term. Returns from government bonds have been significantly more modest, although the asset class has been supported by the distortions arising from quantitative easing (QE) and yields have remained close to historic lows.

Looking to 2013, the overall environment is one of uncertainty although some of the risks that were significant headwinds in 2012 – such as the Chinese leadership transition and a complete disintegration of the eurozone – are perhaps less concerning for markets than they were a year ago. Moreover, in the eurozone, there is now at least a recognition that very tough decisions lie ahead – as a number of European politicians have indicated, they all know what to do to address the debt crisis, but don’t know how to get re-elected if they do it.

We have held a very cautious view of the global economic environment for some time, and events over the past year have proved our caution to be well founded. We continue to expect that the economic outlook will remain challenging in 2013 and the overhang of debt will cast a heavy shadow for an extended period. For this reason, in many of our portfolios we remain cautious on companies that are heavily reliant on government spending. In the US, we expect GDP growth of around 1.5% in 2013, while the eurozone is likely to remain in recession, with GDP contracting by 0.5%. Japan is likely to see a slowdown in growth to 0.7% in 2013, while the UK will see a modest recovery in GDP growth to 1% for 2013. Growth in the emerging world will be considerably better, although the rebalancing of China’s economy is likely to result in GDP growth of just below 8%.

On a more positive note, we believe there may be some grounds for expecting some improvement in macro data in the near future. In the US, there have been a number of better-than-expected data releases recently, and the housing market appears to be

Mark Burgess Chief Investment Officer

Leigh Harrison Head of Equities

Jim Cielinski Head of Fixed Income

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showing a useful recovery, even before any beneficial impact from the Federal Reserve’s third round of QE. While the earlier uncertainty over the outcome of the US presidential election has now been resolved, and President Obama is back in the White House, the fiscal cliff continues to cause concern and has led to the postponement of corporate capital expenditure. This is a worry because it has a knock-on impact on job creation and economic activity.

We expect more details of measures to tackle the fiscal cliff shortly, and this may release some pent-up demand in the more predictable environment that should follow. Moreover, while politicians may be slow in coming to an agreement over the fiscal cliff, our US equities team believes it is very unlikely that lawmakers will actively try to legislate another recession.

Meanwhile, the news from China shows signs of the economic slowdown having bottomed, which is a clear plus for equity markets and risk assets generally, as the emerging world remains the primary motor of global economic growth. The latest official purchasing managers’ indices in China have been above the crucial 50 level (the level that separates expansion from contraction), and the recent destocking phase appears to be largely over. In addition, the leadership transition is now in progress and some further policy stimulus could be on the cards in 2013.

At the corporate level, we have generally lower than consensus forecasts for corporate earnings growth in 2013. The most recent US reporting season (Q3 2012) has been a fairly mixed one, with a higher percentage of disappointments than we have seen for some time, although the pace of downgrades to forecasts appears to have slowed. The scope for earnings to disappoint even as macroeconomic tail risks appear to be abating highlights, in our view, the importance of making the right stock selection calls, as well as investing in the most appropriate blend of assets for a given risk/return target. The easing of tail risks in Europe and China leads us to be more positive on equities than we have been for some time, but there will be bumps in the road as stock markets react to the latest policy initiatives and developments. At a micro level, we expect the strong to continue to get stronger in the equity space and M&A activity is likely to remain an important driver in a number of markets as companies put their excess cash to work.

In fixed income, we continue to question the appeal of so-called safe haven core government bonds such as UK gilts and German bunds – yields remain at historically low levels (and are particularly unattractive in real terms) – and the risk of capital losses down the road is significant. The US treasury market faces similar concerns, although the continuation of QE by the Fed means that yields are unlikely to balloon in the short term. Higher-yielding areas of fixed income such as emerging market debt and high yield look more appealing to us, although strong returns from these asset classes over 2012 to date and significant spread tightening mean that it is much more difficult to make a strong valuation case for these areas than it was a year ago.

Alternative assets are likely to remain popular for investors who are uncomfortable with the volatility that is inherent in equity investing, although we are cautious on UK commercial property as demand remains weak outside of the ‘super prime’ sectors such as West London offices. In commercial property markets, we expect income to be the primary driver of total returns as occupational markets remain weak and the problems in sectors such as UK retail are well known, with a number of household names going to the wall over the past year.

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We expect commodity markets to be pulled in different directions in 2013, with the latest round of QE most likely to benefit precious metals. We see tight supply conditions in the oil market, and a shock to production cannot be ruled out given Middle East tensions. However, buoyant agricultural markets should lead to heavy planting, which may limit future gains. Furthermore, the sluggish global economy and the shift in China from investment-led growth towards greater emphasis on consumption are negative for industrial metals. However, even with these caveats, commodities are likely to remain very popular with investors looking for a hedge against the longer-term inflation risks posed by QE. Moreover, commodities can provide significant diversification benefits when incorporated as part of a multi-asset portfolio.

Investors head into 2013 knowing that few of the fundamental economic problems in the developed world have been solved – and many of them could remain unresolved at the end of 2013. However, as 2012 has shown, a situation which improves from horrible to bad is one in which astute investors can generate attractive returns from risk assets.

Investment themes for 2013

Will the search for yield become a stretch?

At first glance, it might appear as if little has changed in core government bond markets –yields are at historically low levels (with real yields in negative territory in some cases) and doubts remain over the long-term viability of the eurozone. But while these themes are as relevant today as they were a year ago, the forces behind them, and indeed market valuations, have changed considerably. The search for yield, for example, is turning into a scramble, while the pressures of austerity bearing down on eurozone peripherals such as Greece, Spain and Portugal are finally being offset by some support from policymakers – so much so in fact that it has been possible to make significant money from the tightening of peripheral spreads in recent months.

We believe there will also be one other critical difference between this year and next. In 2012, fixed income investors have enjoyed a relatively easy ride with all areas delivering robust and, in some cases, spectacular returns. By contrast, successful active management is likely to be a more significant determinant of returns in 2013 as valuation concerns could provide headwinds for a number of fixed income markets. In short, it will not be so easy to make money in fixed income in 2013 as it was in 2012.

In the equities space, shares in large-cap, high-yielding companies with strong balance sheets, robust cash flow generation and proven capital allocation strategies are also likely to remain in demand, particularly as the shares in such companies often provide a higher yield than their bonds.

In emerging market sovereign debt, there will be an increasing realisation that certain sovereign issuers are more deserving of safe haven status than developed peers. Typically, emerging market economies are characterised by superior growth, relatively low debt and high FX reserves. Turkey’s recent upgrade to investment-grade status by Fitch is one indicator of how far the emerging economies have come. Emerging market corporate bonds can also provide a useful pick up in yield for investors and in most instances the issuers are supported by the discernibly better economic fundamentals than those prevailing in the developed world. However, there is likely to be a limit to how much further emerging market spreads can tighten in 2013, given current levels.

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UK commercial property continues to offer a decent pick up in yield over gilts but overall demand for the sector remains weak and significant refinancing needs to be undertaken. In this environment, property funds focusing on sustainable but higher-than-average yields and possessing the firepower to take advantage of distressed valuations should be well placed.

Survival of the fittest

In terms of equities, we continue to expect the strong to get stronger in 2013. Poor management, flawed business models and weak franchises are very likely to struggle in the tough economic environment, while proven management teams with strong franchises should prosper. Many of these quality companies are inexpensively valued, affording them significant scope to outperform. Examples of strength include:

Nestlé – an exceptionally strong balance sheet, a high yield and category-leading products in a relatively defensive sector, with good exposure to emerging market growth.

Reed Elsevier – this high-quality media company has high returns, exceptional cash generation and a strong dividend. The current valuation does not fully reflect this and we believe that its well-regarded, relatively new management team should continue to deliver and ultimately create value for shareholders.

Marks & Spencer – we estimate that M&S will have a double-digit free cash flow yield in a few years’ time. Unlike many retailers, M&S is not reliant on attracting younger shoppers to drive growth – a clear positive given that the younger demographic groups have been hit hardest in the recession.

Cobham – Defence stocks generally have suffered due to concerns over government spending cuts. However, even in a worst-case scenario, Cobham’s margins should remain healthy and it is likely to take a bigger slice of defence budgets as its applications take market share from rivals.

Growth in a low-growth world

We continue to favour companies that offer growth in a low-growth world. These include:

Companies selling into emerging markets, such as VW in Europe.

Businesses with access to a secular theme such as the provision of cost-effective healthcare services to ageing populations – for example, DaVita of the US.

Companies with superior products or intellectual property that should help to cushion them from the economic cycle, such as Apple.

No such thing as a safe haven

The sustainability of AAA sovereign credit ratings in the developed world will remain a source of consternation in 2013, both for the ratings agencies and investors. The potential for further gains from core government bonds is limited and the risk of loss is significant, given that yields have a very long way to rise before they return to long-term averages. In this environment:

Investors seeking low risk assets will have to look beyond core government bonds.

Absolute return approaches are likely to remain popular.

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Commodities – Stay selective

A selective approach is likely to remain important in 2013. Commodities where supply dynamics are tight, such as oil and related products, should offer better prospects than areas that are tied to the strength of the global economy (such as industrial metals). Oil and related products also provide useful protection against any supply shocks or political concerns in the Middle East, as Saudi Arabia continues to play the key role in balancing global oil markets. Shale gas is likely to remain an important theme in the US – indeed some have already dubbed the US ‘Saudi America’ – but shale gas cannot be exported, so this will be a domestic US story.

Important information

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