2013 outlook: Where should you put your money amid ongoing sluggish growth?
Over the fourth quarter of 2012, global capital markets saw heightened volatility but with minimal forward progress as securities prices reacted to news surrounding Americas fiscal cliff negotiations.
Since last summer, the potentially lethal $600 billion one-two punch of sweeping tax hikes combined with broad government spending cuts had been hovering like an executioners sword over the fragile US economic recovery.
What began early last year as a soft murmur amid the typically noisy Wall Street chorus steadily rose to a loud crescendo by year end, swaying markets in either direction depending on the latest news about a possible deal.
As we had predicted, a compromise was ultimately reached at the eleventh hour.
Economically, the global recovery remained on its bumpy but upward trajectory over Q4 as it has since the depths of the Great Recession.
On the plus side, Americas massive money-printing scheme has begun to produce some results.
For one thing, real estate prices are beginning to move upwards on record low mortgage lending rates and better employment data.
The US unemployment rate fell from a peak of 10.0% in October of 2009 to a three-year low of 7.8% in December.
While the US is still lumbering along in what we refer to as a muddle-through economy, Europe has not been as fortunate. Generally reactive policy measures plugged a few gaping holes in the euro zone debt crisis but have not been enough to reignite growth.
The most recent unemployment rate in the euro zone remained alarmingly high at 11.4% in Q3 2012 and is projected to rise to 12.0% this year.
Meanwhile, Asia, led buy China has shown signs of reaccelerating growth as evidenced by stronger manufacturing and export data.
Riskier bonds outperformed higher grade securities in Q4 continuing a trend which began over a year ago at the nadir of the euro zone credit crisis.
Bond investors have since grown increasingly complacent about the possibility of major negative credit events worldwide.
Even less stable European corporate and sovereign securities saw spreads tighten through the back half of the year gaining further momentum after European Central Bank (ECB) vowed to do whatever it takes to save the euro.
Exemplifying the dominance of the risk on credit trade, lower grade bonds around the world outperformed investment-grade debt in 2012 year by the biggest margin since 2010.
Sales of so-called junk bonds worldwide soared 35% to a record $425 billion in 2012.
Looking ahead, we see somewhat less opportunity for bond prices to gain on tighter credit spreads.
More likely, fixed income markets will stay range-bound, selling off when investors feel more confident about taking risk but also poised for sharp rallies during periods of risk off market sentiment.
Overall, our fixed income strategy remains opportunistic and we continue to find relative value within attractive market sectors.
Furthermore, the positively sloped yield curve allows numerous possibilities for riding down the curve by taking profits on bonds prior to their final maturity.
Despite last years increase in stock prices, we still see opportunity in select equity strategies.
On the plus side: by historical standards stocks are not terribly expensive; many companies have become much more efficient; corporate cash levels are high; and equities may be relatively under owned.
At the moment, market valuations are not especially demanding despite prices having broadly recovered since the dark days of 2009.
In fact, a global basket of stocks is currently about 12% cheaper than five years ago despite an increase in corporate earnings since then.
Moreover, the global stock markets price-earnings ratio (P/E), a standard measure of market valuation, is trading at 13.1X forward earnings, below its ten-year average of 13.9X according to Bloomberg data.
Globally, corporate earnings are expected to increase more than 10% in the coming year.
In terms of fundamentals, many companies have cut costs to keep margins high and operate in a low growth environment.
Companies running lean and mean could show significant profit leverage if revenues turn back up.
Additionally, the credit crisis and fiscal uncertainties have motivated corporations to hoard cash and even return it directly back to shareholders.
A general improvement in the economy now has the potential to accelerate business capital spending which has recently been a growth drag.
In the meantime, many companies are using cash to reward shareholders through stock buy-back programmes and increased dividends.
Perhaps one of the more overlooked potential positives for equities is that stocks as an asset class appear to be generally under owned by both individuals and institutions.
A Gallup survey concluded US household equity ownership had declined from 67% in 2002 to just 54% by the end of 2011.
Another determined that endowments had reduced their weighting in equities from 50% in 2002 to 33% over the same time period.
Even recent data from Morningstar suggests that investors continue to favour bond funds over equity funds for new commitments suggesting that a sea change in the other direction could be a significant price driver in the future.
Over the coming year, we believe that high quality securities which benefit from market leadership positions should continue to fare well.
Importantly, investors should consider holding companies which systematically return capital to shareholders through stock repurchases and/or consistent dividend payments.
Putting it all together, we recommend that investors remain broadly diversified among strategic asset classes, opportunistically rebalancing portfolios in a disciplined manner and as tactical opportunities are presented.
Given what we see as an ongoing sluggish growth environment, volatile capital markets and an ageing demographic with the OECD countries, we continue to favour higher quality, cash generating and income-producing securities, investing in a price-sensitive manner.
Bryan Dooley, CFA is a senior portfolio and fund manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their investment advisor if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.