Unknown quantity

A year ago the general consensus was that gilts were overpriced, yet during 2011 UK gilts and UK index-linked gilts were by far the best performing investment sectors. In contrast, it was thought by many that equities were relatively cheap, but over the course of the year stock markets have fallen further.

Crystal ball

We have seen time and again that predicting what will happen in the future is almost impossible. To use the words of renowned economist JK Galbraith: “There are two kinds of forecasters: those who don’t know and those who don’t know they don’t know.”

What we can say is that defensive assets have performed well in 2011 as investors have shied away from taking risk, and so, unsurprisingly, riskier assets such as equities have performed badly. The end result is that gilts and good-quality fixed-interest is more expensive in 2012 than last year, when it was considered expensive, and equities, particularly riskier growth stocks and emerging market equities, are much cheaper than they were last year, when they were considered to be cheap. This continued divergence in valuations can create opportunities for investors who are prepared to take greater risks.

Unfortunately there are no guarantees that those who take more risk will be rewarded for doing so, particularly in the short term. The outlook for economic growth in the western world is muted at best and there are fears that some regions, particularly Europe, could be dragged back into recession.

It is macro-economic issues, such as the European sovereign debt crisis, which have been driving stock markets, with all stocks rising or falling as a result of the same piece of economic news or latest indicator. This again can create opportunities to buy cheap as good-quality stocks are being unfairly punished.

Macro news may continue to direct stock markets in 2012 and particularly developments in Europe. We don’t believe that the eurozone will break up in 2012, but its longer-term future remains uncertain and we won’t see an end solution to the problems in the region in the short to medium term. It is possible we will see the European Central Bank attempt to launch a fiscal union in 2012 and if this fails then consider quantitative easing to stimulate European economies.
We just hope that there are positive indications that the problems are being adequately addressed and that any actions are viewed favourably by markets.

We also need to see that debt levels are going to be addressed in other areas of the world, particularly in the US where there is a danger that a political stalemate in Washington could hinder any significant progress until after the presidential election. However, there are a number of encouraging signs coming from the US, including more positive economic indicators, corporate earnings beating expectations, and companies starting to return excess cash to shareholders in the form of buybacks, dividends and special dividends. This is all good news for stock markets.

Hit parade

In the UK we have seen defensive stocks such as blue chip pharmaceutical and tobacco companies outperforming in 2011 as equity investors seek a flight to quality. In this environment, it is no surprise to see the defensively minded Neil Woodford in first and second place in the UK equity income sector in 2011 with his Invesco perpetual income and high-income funds, despite having to manage nearly £20bn of assets.

While UK investors must now pay more of a premium to access some of these stocks there is every likelihood that high-quality defensive companies, with strong balance sheets and paying consistent dividends, will outperform in 2012. If that is the case, then it would be no surprise to see Woodford near the top of the charts again next year.

After a strong start, UK smaller companies funds had a torrid second half of the year and again recent falls could create buying opportunities. However, the economic recovery in the UK is far from certain and any fall back will impact most of those smaller companies which earn the bulk of their revenue from their domestic market.

Like UK smaller companies, emerging market equities have suffered terribly as investors decided to reduce risk and sell out. The global emerging market sector performed poorly in 2011, with only the specialist region of China and Greater China doing worse. This will have impacted significantly on the portfolios of investors with high exposure to emerging markets and highlights the risks involved, even when these regions are still providing real economic growth.
There will continue to be high levels of volatility in emerging markets, and particularly for those who are brave or stupid enough to invest in individual emerging market countries, but at current prices there are also likely to be some good long-term opportunities, particularly if investors start to show a little more appetite for risk again.

Japan is worth mentioning, but there have been so many false dawns in the region already that it is difficult to have any real confidence in Japanese equities. While the country boasts some excellent companies, Japan is burdened with huge levels of debt which it doesn’t look capable of repaying; it needs to invest in infrastructure following recent natural disasters and the appalling demographics in the region will do nothing to stimulate economic growth. Japan will have periods where it will outperform but the longer-term prospects aren’t looking too rosy.

Companies house

Despite all of the economic doom and gloom it should be remembered that companies are different to countries. While many economies may be struggling, this doesn’t preclude these countries from housing firms that are performing well, generating profits and sitting with large cash reserves on their balance sheets. When the markets pay closer attention to company fundamentals rather than being driven by macro-economic events, many of these companies could benefit from a significant re-rating.

We have already stated that gilts look very expensive at current valuations but that doesn’t mean they haven’t got further to go if we get more bad economic news. However, we wouldn’t be buying at these levels.

Most investors should have some exposure to fixed interest in their portfolios to provide protection against falling stock markets and often this is made up by investment grade corporate bonds. These have also proved popular as investors have sought quality and at best they can be said to be about fair value. It is likely that there won’t be significant gains or losses from this asset class in 2012.

As is usually the case in times of uncertainty, the best value is often with the riskiest assets which are unloved by other investors. There is an argument that high yield bonds could perform well in 2012. However, the performance of high-yield bonds is often highly correlated to stock markets and so they might not provide much protection if markets fall.

For many investors, strategic bond funds are a sensible way to get exposure to fixed interest in their portfolios. However, it is important to understand that these funds can adopt significantly different approaches and so there is likely to be a wide divergence in the amount of risk they take and how they perform.

Commercial property can also provide some protection from falling stock markets. However, while many equities appear to be sitting at attractive valuations it is difficult to say the same for property. It would be no surprise if the performance of property is fairly muted for several years to come, with rental income making up a significant proportion of the overall return. However, the potential for consistent long-term returns coupled with the diversifying nature of property means it should be held in most investment portfolios.

As always, the right approach for investors is to hold a balanced and diversified investment portfolio. In ?the current environment investors must be wary of taking too much risk as riskier assets such as equities are likely to remain volatile and investors must be prepared to accept short-term losses. However, investors must also be wary of taking too little risk. Currently more secure assets are expensive and riskier assets are cheap, so, while investing in safer assets will provide greater capital protection, there will also be far less growth potential.

Patrick Connolly is a certified financial planner at AWD Chase de Vere