Going into 2013 there are a number of investment themes to consider. Long term forecasts suggest that equities will produce the best total return over the coming years, while cash and government bonds will produce returns that will struggle even to match inflation. The market moves seen in late 2012, however, make us less confident to back the positions suggested by these long term returns.
Looking at cash first it seems clear that interest rates in most currencies will remain close to zero this year. Even if economies were to continue recent improvements policy makers will use such improvements to tighten fiscal, rather than monetary, policy. So while cash is the asset that will not actually go down in value, the likely return on it will remain extremely low.
? Next on the risk spectrum is government bonds. Here yields are at extremely low levels from which it will not take much in the way of yield increases to produce a negative total return. Any sustained improvement in the global economy, abandonment of bond buying by central banks, or suggestion that interest could rise in the future are likely to see bond yields rise. Core government bonds are thus our least favoured asset class. Corporate bonds still offer a yield pick-up over government bonds that will more than compensate for any losses from companies defaulting. Company finances remain in good shape.
However the yield pick up for both investment grade and high yield bonds has fallen significantly in 2012. As a result the capital gains from further spread tightening that drove the strong returns in 2012 are largely behind us, leaving prospective returns more modest.
We remain overweight corporate bonds and can still see yields spreads falling further, but will act to reduce overweights if spreads tighten significantly further.
Turning finally to equities, they still look set to produce the best returns over the long term, and we may be seeing portfolio rotation by investors out of bonds into equities on a long term basis. However expected returns are modest in comparison with recent market moves, and there seems to be an element of complacency creeping into the market at the moment.
We thus maintain only a small overweight in equities and will continue to take profits into any further rallies to keep positions at modest levels. If the news turns worse for any reason and markets suffer significant setbacks, we will be ready to more aggressively increase equity weightings, but feel the time is not right at present.
In some ways the worst case scenario for investors is that corporate bond spreads continue to tighten and equities continue to rally, thus eroding long term value in these asset classes at a time when prospective cash and government bond returns remain low. If this happens the right approach will be to reduce portfolio risk and accept low returns while waiting for value to appear once again.
However there are many factors that could prevent such a scenario from developing. Although much noise has been made about the deal to avert the US fiscal cliff, the fact remains that the cliff was merely a symptom of the underlying disease of excessive debt, which remains. And not just in the US. Europe and Japan also labour under high debt burdens, so that the global economy will continue to struggle for sustainable growth. Asset markets are currently focused on improving growth trends, but this could change at any time. We are therefore cautiously positioned.
The government has maintained its guidance of prudent monetary policy and proactive fiscal policy for 2013. However, based on recent stronger data, the likelihood of further policy easing by government has partially subsided for now. The government is also fast tracking investment projects and has introduced measures to raise consumption and support the corporate sector facing challenging demand conditions. We expect earlier policy easing to continue feeding through to support a modest pickup in growth this year. We expect pro-growth policy to continue feeding through to support stabilization in growth into 2013.
We expect a cyclical recovery in the local economy in 2013. After months of earnings downgrades, we are seeing signs of stabilization in consensus forecasts. This sets the scene for a rebound in corporate profitability in the coming year. This, together with ample liquidity with the continued capital inflow into Hong Kong and attractive valuation, will be the key drivers for the Hong Kong market in the next 12 months. As China becomes more aggressive in its countercyclical policy, sentiment should improve and lift the Hong Kong market up. We also believe that if and when the Chinese economy shows signs of sequential improvement, domestic Hong Kong stocks might significantly underperform their Chinese counterparts.
We expect any rise in bond yields in 2013 to be modest, given ultra-low central bank rates and ongoing risks, such as the US debt ceiling increase, to be resolved in Q1 2013. Casting an overhang on the euro zone debt markets is the possibility that Spain will eventually have to ask for a full bailout, as well as, the February elections in Italy which could produce some uncertainty over its commitment to reduce the deficit. We prefer corporate bonds and emerging market debt from both fundamental and valuation perspectives. Company fundamentals are generally supportive of corporate bond markets as balance sheets are mostly in good shape and many companies are cash rich. This should provide a cushion that will help to shield them from the impact of banks reducing their loan books and slowing global growth. We expect any deterioration in credit quality to be moderate for the majority of companies, even if the global economy slows.
The British pound’s weakness is set to emerge from the shadows in 2013, with UK’s fiscal credibility is under scrutiny and the threat of a sovereign downgrade looming. The path of Japanese yen will be determined by whether the market remains confident the new government will ultimately implement the radical easing measures proposed in the run-up to the election. We expect moderate RMB gains early this year, supported by favorable cyclical and seasonal factors. Further ahead, one should be prepared for the RMB internationalization to develop at a rapid pace. The outlook for most Asian currencies has turned for the better and we expect this to continue through 2013. There are two factors at play that should see investors pivot towards Asian currencies. First, global tail risks are subsiding, particularly in the Euro zone. Second, growth in Asia is turning stronger, which should benefit the cyclical nature of the region’s currencies.
We believe gold could benefit from the debasement of money as central banks engage in more money printing via QE and, more generally, high levels of uncertainty. The lack of visibility with regard to the resolution of the European debt crisis and the looming fiscal tightening in the US in our view provides support for gold. Despite the recent rally on the back of expectations of further monetary loosening by the US Fed, crude oil still offers opportunities in the event of a cyclical recovery in a context of accommodative monetary policies (i.e. record low interest rates and QE). Commodities as an asset class tend to be particularly volatile. That said, Russian equities, which give significant exposure to energy and hard commodities, and Latin American equities, which give exposure to both soft and hard commodities and commodity-related currencies, are indirect ways we invest in the commodity theme.
All returns are in terms of local currencies
Source: HSBC Global Asset Management (Hong Kong) Limited