March 2012: SH: Investment Outlook – Market Commentary and Outlook

The Greek Bank index rose close to +160% between early-January and the reaching of agreement on the Greek bailout, but fell over -25% over the following 72 hours, reminding investors it is often better to travel than arrive. However, the euro has continued to strengthen, closing the month not far from the middle of the range of the last five years versus the US dollar (1.33 at the time of writing compared to a 2010 low of 1.19 and a 2008 high of 1.60). Elsewhere, the strong start to the year in equity markets has been led by those sectors and countries that lagged last year. In particular, financial stocks have bounced strongly and emerging markets have outperformed developed markets.

Investment conclusions
Turning to the current environment, the relative stability in commodity prices over the last twelve months is expected to bring down the rate of inflation.
We see global inflation moderating from 3.8% in 2011 to 2.6% in 2012 and continuing to decline in 2013. This provides a favourable backdrop for both equities and bonds. Typically such a period of stability is a good time to buy insurance as this is when the cost of insurance is low.
This is far from the case in the current environment. Government bonds are the obvious hedge against deflation. However, yields are too low to expect positive returns over the long-run in the absence of a prolonged period of deflation, something we see as highly unlikely. Gold is an obvious hedge against inflation but can hardly be described as cheap after eleven uninterrupted years of gains. Still, we continue to see a roll for gold in an environment where the major central banks are all pursuing quantitative easing in one form or another. Volatility is currently towards the bottom end of its range but this reflects shortterm trends rather than long-term hedging costs (see chart 4).

Overall portfolio risk levels remain at cautious end of scale
There are two factors that leave us cautiously positioned. First, we have ongoing concerns about the deleveraging process in Europe and the US. The crisis in Europe has eased due to the efforts of the European Central Bank and agreement on Greek debt restructuring. However, the Greek bailout is doomed to fail as the country cannot grow with the level of austerity being imposed.
Beyond Greece, a sustainable solution can only come with political union. It seems inevitable to us that we will need to see a few more crises before this can be achieved. This was amply demonstrated by the weekend agreement on the new set of fiscal rules. Within hours of leaving the meeting, the Spanish Prime Minister Mariano Rajoy announced that Spain intended to breach the rules he had just signed up to. “This is a sovereign decision that Spain has taking” he announced, highlighting that sovereign considerations outweigh the desire to move towards a closer cooperation.
Secondly, the US economy also looks vulnerable as we move into 2013. The political parties will need to agree a new stimulus package as a number of existing programmes expire at the same time as presenting a credible long-term financing plan to appease debt rating agencies while fighting an election. Risks of a policy mistake are high and a recession next year is a real risk.

Favour strategies that profit from rising volatility
Our expected portfolio volatility is also low because of a positive view we have on a number of investments that act to reduce overall portfolio volatility. We favour those investments that can profit when volatility rises, which is generally associated with periods of falling equity markets and rising credit spreads. Fund manager of BH Macro, Brevan Howard trades in the major fixed income and currency markets. They have proved adept at profiting when market volatility increases, while avoiding losses as calm returns.
CQS Credit invests both long and short in corporate credit. It is also structured to profit during of market stress that lead to spread widening while trading more tactically when volatility is declining.

Equity valuations relative to bonds more than compensate for risks
Equities will suffer if we are wrong on our near-term forecasts for inflation in either direction.
Neither significant inflation nor deflation are positive for the valuation of equities. However, valuations have fallen to levels where long-term investors are sufficiently compensated for taking this risk. Profitability is high and this creates risks too as it will revert to the lower mean over time.
However, we do not see wage pressures acting to put downward pressure on profitability over the next 1-2 years. For now, the greatest threat to equity markets remains an unexpected downturn in ecomomic growth.
We continue to favour quality companies, defined by characteristics such as strong balance sheets, a secure dividend and a sustainable business model. We also see value in “value”, those companies trading on low valuation measures relative to the market. Buying companies in out of favour areas of the market has historically proved to be a successful strategy but must be seen as a long-term investment as managers pursing this strategy can suffer prolonged periods of outperformance.

Energy equities for the long-term
We see a strategic role for energy equities in portfolios. We are confident that emerging market demand will lead to tight markets in a few years time. In the shorter term, this exposure may offer something of a hedge against further instability in the oil producing nations of the Middle East. However, these shares are likely to fall less than the market rather than actually rise in the event of any conflict with Iran.