Outlook 2012: End of the Debt Super Cycle
Posted on: 05 Jan 2012 by James Cholmondley Farmer

Investors are faced with tremendous uncertainty about

where the global economic and political situation will take

financial markets. This outlook describes the key drivers

behind the current developments and identifies investment

opportunities in this fast moving, profoundly challenging

environment.

The most important thing right up front: The global economy

currently seems to be not just in a classical cyclical downturn,

but at the beginning of a structural transitional period.

This transition might accompany us for longer and ultimately

lead to significant social and economic transformation, especially

in some industrialised countries.

Marked by unrest, disasters and a sovereign debt crisis

In 2011 investors were repeatedly confronted with bad news

that heightened uncertainty about further economic developments.

This led to a huge rally in government bonds from

safe-haven countries. Strong price swings in risky assets left

many investors with disappointing performance results.

Since the very beginning of the year, the so-called Arab

Spring spread across several states in the Middle East and

Northern Africa, with people protesting against authoritarian

regimes and the ruling political and social structures of these

countries. In March 2011, the devastating earthquake and

tsunami as well as the ensuing nuclear disaster in Fukushima

painfully demonstrated how vulnerable even high-technology

economies are in the face of natural disasters. And

finally, since spring 2011 financial markets have had to deal

with the sovereign debt crisis, with worries about a general

financial meltdown and the possibility of double-dipping

economies.

Slow growth but no global recession in 2012

The current problems – structural imbalances, excessive debt

levels and slowing economic growth momentum – will not

disappear overnight. But the good news is that financial markets

largely discounted these facts. This leaves investors with

the crucial question of whether the fundamental conditions

and market sentiment will improve or further deteriorate.

Our baseline scenario for 2012 is that economic growth momentum

will continue to slow on a global scale – at least in

the first half – but that a global recession can be avoided. The

economic backdrop in the US looks rather resilient, with the

Fed following an aggressive reflationary policy. Recession

risks are mainly concentrated in Europe – particularly in

some debt-burdened eurozone economies – and in Switzerland,

which suffers from the overvalued Swiss franc. Lower

growth trends further suggest that disinflation and deflation

risks will persist in Europe and Japan. European central banks have already reversed steps towards policy rate normalisation

and are set to cut rates further in 2012.

Stagnation in the west will take its toll on export-led developing

economies. This is going to disenchant many decoupling

dreams, at least in the short run. Yet emerging markets

should remain the global growth engine, as this status is

strongly anchored in structural facts like favourable demographics,

rapid progress of industrialisation and urbanisation.

What counts are real yields

The persistent large structural as well as cyclical imbalances

and the associated adjustment processes make the world

economy increasingly vulnerable to shocks and crises. The

consequences are (permanently?) increased levels of uncertainty,

resulting in high market volatility. It is no surprise,

then, that the current low-yields-meet-high-volatility environment

is shaping the key investment themes for 2012:

“The search for yield” and “preservation of capital”. This may

at first sound contradictory, but not if we add the all-important

word “real”, as both themes only make sense in real

terms, even if we find ourselves in an environment with

mostly moderate inflation.

The impressive rally in some safe-haven government bond

markets has resulted in negative real yields, which leads to a

gradual destruction of wealth and purchasing power for

those bondholders. Combine this with the continued need for ultra-expansive monetary policy and quantitative easing in

the developed world and it becomes crystal clear that cash

positions and «safe» government bonds – for example in the

US, UK, Germany or Switzerland – are unattractive and

should be avoided as long-term investments. The extremely

low interest rates provide no margin for error, especially for

holders of bonds with longer maturities.

Opportunities in fixed income

In this slow-growth environment, we prefer selective fixed

income investments in corporate bonds – both investment

grade and high yield – as well as emerging market debt. To

us, this is more attractive because such investments help reduce

a portfolio’s concentration risk, improve diversification

and are well supported by fundamentals and valuations.

Outside of the fixed income area, the pessimism and fear provide

opportunities for investors who are willing to take a different

angle and accept a longer investment horizon.

Opportunities in the equity markets

For equity investments, conditions could easily get better – at

least at the margin – with the new reflation cycle that has

begun, with any progress in the debt crisis debate or with

signs that the corporate sector is more resilient than anticipated.

Furthermore, any positive development in the euroarea

debt and liquidity crisis might lead to a sudden one-off

upward revaluation in risky assets.

We recommend that equity investors focus their shopping

list on markets, sectors and themes that are in a secular uptrend

and therefore have more durability and structural tailwinds

in the months and years ahead. With overall profit

margins near historical highs, we recommend focusing on

carefully selected stocks from companies with strong and

stable earnings, potential for productivity growth, and a leading

position in their area of expertise. An active approach

to stock selection certainly looks more promising than pure index replication in the current environment. Our proprietary

bottom-up stock selection process currently identifies attractive

stocks especially in the technology, healthcare and energy

sectors. In this context, focusing on themes that benefit

from the secular trend of Asian consumption growth can help

investors capture additional returns. Demographics, industrialisation,

urbanisation and increasing wealth for the upper

and middle class will remain strong drivers for growing demand

in energy/natural resources, food/agriculture, healthcare/

life science and luxury goods.

Attractive upside in selected commodities

Commodities are another asset class with a decent mediumterm

risk-reward profile and attractive upside potential driven

by secular strong demand. Especially energy (oil) remains

in elevated demand and could easily become subject to supply

shortages any time. However, an active and selective approach

is needed in the commodity space, too. Despite a major

correction in recent months, we believe that gold might

again move higher adhering to its long-term uptrend, especially

with the ultra-expansive monetary policy and quantitative

easing we can see from central banks around the globe.

Stefan Angele, Head Investment Management, Member of the
Executive Board, Swiss & Global Asset Management

 

Tags: 2012 | IFA | invest | money | rdr