Investment Note January 2013

TAM Outlook for 2013

“As last year, our elected (and un-elected) leaders will be faced with tough decision to ensure the economic recovery remains on track.” – Lester Petch, CEO TAM Asset Management Ltd

We believe that 2013 will be another year of opportunity for investors able to proactively position themselves to deal with periodic volatility and market dislocation. The fragile economic recovery which started in 2009 remains weak but resilient enough to overcome the many headwinds it faced last year.The unprecedented efforts undertaken by governments and central banks around the world underline the fragility of the recovery and will be a key factor driver for markets throughout 2013. We believe there will be a clear polarisation between the performances of individual asset classes and asset allocation will be the key to performance this year.

  • Equity Markets: OVERWEIGHT.  We believe equity markets are undervalued by historical measures and could end 2013 higher by some 12% despite sporadic periods of volatility. With only modest growth in the global and UK economy, and the hunt for yield mostly played out, it will be necessary to identify stock specific growth opportunities, rather than relying on index performance.
  • Fixed Income markets: UNDERWEIGHT. Sovereign debt, OVERWEIGHT Corporate Debt.  Fixed income markets have become polarised since 2008 with leadership shifting from sovereign bonds, in 2011, to corporate bonds last year.  We expect a continued shift away from negative real-yielding sovereigns towards higher yielding corporate issuers as inflation moves back on to investors’ radars and forces them to embrace more risk in the search for higher yield.
  • Property: UNDERWEIGHT. We see little to encourage us to re-enter either the residential or commercial real estate space this year.
  • Commodity: UNDERWEIGHT. The decade long switch from paper (equity) assets to hard (commodity) assets has run its course.  There will be short term opportunities if global, and particularly Chinese, growth picks up faster than expected but we will retain only a modest exposure to the sector at most.
  • Absolute Return: OVERWEIGHT.  We continue to find the risk-reward of absolute return strategies more attractive than the UK Government Gilts against which we benchmark this asset class.  We expect another year of steady positive returns less vulnerable to a sharp increase in bond yields whatever the catalyst for that may be

Review of 2012

The UK stock market ended in the black with the FTSE100 Index posting a 5.8% return for the year, the US stock market made double-digit returns and Europe also saw a major recovery despite negative eurozone headlines dominating most of the year.  In terms of economic activity, both the US and Germany returned to where they were before the Lehman crisis.  Even the Japanese stock market rallied into the last few weeks of December. On the face of it then, it was a good year to be overweight equities.  In hindsight, however, it was a fragile stock market built on low volumes and easily spooked by disappointing economic news or, more often, by geo-political events ranging from the Arab Spring, new tensions between China and Japan and seemingly insoluble eurozone saga.  The FTSE100 lost around 10% in May in a fortnight in response to yet another disappointing G8 summit that delivered little in the way of reassurance of credible policy responses. Then, having more than recovered in the summer, November saw stocks get hit by 5% in the wake of the Presidential election victory for Barack Obama, leading to gloomy short term predictions for year-end and a political battle with the Republicans potentially wiping 4% off US GDP, failing an agreement over the fiscal cliff situation.  The worst case scenario never transpired thanks to a last-minute deal, but not before many had run for the exits. It was a year that tested the resolve of equity bulls and shares did indeed climb a wall of worry.


A Gilt “bubble”?

Looking back at some of the key commentaries and forecasts we made for the market, we don’t believe we would have done anything materially different with asset allocation.  Our bearish stance on Gilts was justified. UK 10-year yields raced up towards 2.5% but fell back again due to a lack of conviction to really take on more risk.  Investors swung back to the perceived safe haven of Gilts through the summer even as equities made a significant recovery. The 10-year Gilt yield finished the year where it began around 2.1%.  The best anyone could do with this asset class was to trade around the trading range which the market deemed to be from around 1.5% to 2.5%, and that is precisely what we did by taking the opportunities where we could at the shorter end of our normal investment horizon but mindful that we are living in a fast changing world. For a number of reasons, we believe the Gilt market will be remain narrowly range bound in 2013 as lingering doubts over the state of the UK economy suppresses the prospect a clear cut rotation into equities.


Equity rotation

Amid the risk-on, risk-off nature of low volume trading, equities were, broadly speaking, the inverse of Gilts.  Given the higher volatility of equities, the TAM investment team decided to limit the basic equity weightings in portfolios to that of close to the benchmark due to the danger of an external shock or unforeseen policy error leading to a painful sudden sell off. However, within equities, we began a shift from yield towards funds exposed to growth, mid to small sized companies and with strategies that rely more on stock picking.  This would hopefully be less affected by large swings in the market index driven by sentiment and prone to indiscriminate selling. This was a particularly successful strategy with almost all the equity investments outperforming the FTSE All Share Index which forms part of TAM benchmarks. It also means that portfolios finished 2012 in equity funds that we believe are very well positioned for growth in 2013. A notable change is the reduced reliance on yield.  Whilst this has been a useful and popular strategy, we believe that it has mostly fulfilled its objective and that the market is now increasingly searching for companies with solid cash flows and growth potential.  Of course, it’s true to say that this can be a common characteristic of companies generating sufficient cash to pay growing dividends, but as we endeavour to invest funds ahead of business cycles, we believe there are excellent opportunities in companies with the confidence to re-invest proportionately more in their own growth and development in a fast changing world polarising between “winners and losers”.  We would expect to see a rising level of interest in growth stocks in the year ahead.


The eurozone saga

It could be argued that, by any objective measure, the Euro experiment has failed and that Greece should be allowed to leave the eurozone. But if the EU is determined to keep Greece in the currency union at any price and, as “Super” Mario Monti (President of the European Central Bank) says he will do “whatever it takes”, then why let free markets get in the way of a political objective?


This one sentence alone has had a greater effect on eurozone bond yields than almost anything else.  It has been highly successful in lowering bond yields for the peripheral eurozone states and removing some stress from the bond markets, and not a single Euro has been spent in achieving it.  This level of respect from markets is normally only reserved for the Federal Reserve.    But it is now clear that the EU and ECB are absolutely determined to keep Greece in the Euro at almost any cost.  Whether that cost is affordable and acceptable to the bulk of German taxpayers is debatable but it has had the effect of lowering the perceived tail risks of a Greek exit anytime soon.


With Germany agreeing to the latest third bailout, it is more likely that Greece will stay in the eurozone into 2014 despite serious social and economic problems remaining.  Unable to control their own currencies and under the hammer of the IMF and EU, Greece and Italy are governed by unelected technocratic governments trying to implement unrealistic austerity measures and that, in turn, is giving rise to higher unemployment and civil discontent. Spanish Prime Minister Mariano Rajoy has been at pains to reassure markets that Spain doesn’t require a bailout, yet it is clear that the true cost of bailing out Spain is probably four times the Spanish government estimate of EUR 100 billion.  With the economy in trouble and an unemployment rate of 25%, in addition to youth unemployment of 50%, 2013 will almost certainly see further civil unrest and a growing clamour for separatist calls from Catalonia and Basque.   Italy is attempting to replace its technocratic government with an elected one in order to restore some semblance of normality and national pride. Prime Minister Mario Monti has gambled on an election victory but the reappearance of Silvio Berlusconi as a candidate for re-election is an intriguing one and a move that cannot easily be dismissed. If Silvio plays to the nationalist ticket on the back of the disgruntled electorate, there could be surprises ahead.


In May, the election victory for Francois Hollande over Nicolas Sarkozy provided another example of incumbent rulers being overturned by unhappy electorates. As was also seen in the Netherlands, whether from the left or the right, incumbents were judged guilty for simply presiding over the crisis, regardless of whether  policies were directly responsible for the crisis or not.  Following a difficult start to his premiership, Francois Hollande has given some hint that his leadership may scale back some of the onerous and potentially damaging tax proposals which launched him to election victory. However, of greater consequence is the change in France’s relationship with Germany.  The Mediterranean states have a heavyweight ally on their side now that France has shifted her stance to that of seeking economic stimulus over austerity.  Reading the politics of the EU has become as important as the economics.  When it comes to Europe, however much you think you know, you never know what’s going to happen next because the political tinkering and brinkmanship between the northern and Mediterranean states, with the ECB in the middle, consistently wrong-foots the markets.


German Chancellor, Angela Merkel, has softened her stance on certain controversial proposals but the priority for her party in 2013 is really just to do enough to secure a second term election victory in the autumn, rather than what’s necessarily best for the German economy today. As long as German taxpayers can be led down the path to ultimately bailing out Greece, and repeated summits can continue to kick the debt can down the road, it is likely that another term as leader will be secured.  After that, there could be some surprising U-turns on policy, such as agreement to issue Eurobonds, for example, something that the market sees as being inevitable.


Outlook for 2013

Considering repeated bouts of market volatility, it’s not surprising that a lack of conviction is evident among investors fearful of being punished for buying into the notion that things are improving.  In short, the stock market has spent 12 months climbing a wall of worry interspersed with panic selling or opportunistic buying. The phrase from 2011 “risk on, risk off” was commonly used throughout 2012.


Stock markets, with ever shorter investment horizons, are getting very good at shaking out nervous investors lacking conviction to stick with good investments they believe to be relatively cheap in the long term.  If you believe that we are in the foothills of a major switch from bonds to equities, then these setbacks present real buying opportunities. This is what we believe at TAM and has been for some time.  Of course, the catalyst for a rise in bond yields, particularly government bonds, is difficult to predict because so much of the structure and balance of the markets is influenced by government and central bank policy.  It’s normal for investors to price asset classes on a relative basis against interest rates, growth and inflation. But if these three metrics are themselves manipulated by policy decisions, it becomes increasingly difficult to gauge exactly what is going on or, more importantly, when.


It also means that government and central bank policy can have a greater effect on stock and bond markets than hard economic data. It’s difficult to justify maintaining a full weight in Gilts, for example, if a single bullish comment from the Governor of the Bank of England could send UK 10-year Gilt yields from 1.5% sharply back up to 1.75%

Actually, in terms of hard economic data, the UK appears to have ended 2012 in rather better shape than many had predicted.  The Olympic effect is debatable but it probably added to GDP in the fourth quarter, giving the UK a stronger growth rate than that of the US or Germany, and way ahead of the eurozone which saw a fall.  If this effect is real, however, it will be short lived and, again, may lead to market disappointment if the UK enters a triple dip recession which will test the nerve of equity bulls.


GDP wasn’t the only positive indicator as 2012 came to a close. Corporate survey data in the form of the Purchasing Managers Indexes have stopped falling, even in the eurozone, as orders have started picking up to replenish falling inventories.  Broadly speaking, the cycle is seeing companies  profitable with better cash flow but, on the other hand, with still plenty to worry about in the US and eurozone, this money isn’t finding its way back into the economy as company boards remain understandably cautious.   When the direction of the economy is finely in the balance, the market remains vulnerable to headline economic data that may be, on the face of it, weaker than expected but turns out to be nothing more than part of a normal cycle to recovery.


No one indicator can be used to predict the true health of the economy. In the USA, for example, the Federal Reserve has switched its mandate from one of controlling inflation to one of targeting an unemployment rate of 6.5%.  Perhaps this is understandable when dealing with an economy flirting with recession but does give investors something new to think about when assessing likely policy changes because there are various different ways to measure unemployment. We think this will be a tough target to achieve for a number of reasons.  Firstly, the unemployment rate is flattered by the number of working-age people either giving up on searching for work or, alternatively, foreign workers leaving the country. Overall, the change has been minimal and the pool of available workers remains high.   This is not to say that the Fed’s new policy is ill-judged but there may be some surprises in store.  For example in the event that the US experiences a robust recovery, we may find that the unemployment rate stays stubbornly high.  However, this may prove a blessing in disguise for equity bulls because, if they didn’t have enough reasons already, the Federal Reserve may be more inclined to keep interest rates on hold.  So we will continue to watch the unemployment figures but will not be surprised to see the target of 6.5% remain elusive.  And of course, the Federal Reserve could suddenly decide to abandon the target as quickly as it adopted it if the economy is obviously firmly in recovery.


More of the same

We stick with the message we gave in August 2012 that the problems of the global economy are far from over but that the time to panic was some time ago.  Barring some unforeseen economic miracle, quantitative easing measures will likely stay in place in 2013 and into 2014 which could underpin confidence for investors to take on greater risk, such as a rotation from bonds into equities.


In the final weeks of December, it was clear that some appetite for risk had finally emerged despite any number of worries over global growth, the eurozone, China, Middle East or, more recently, the political brinkmanship over the US fiscal cliff.


Whilst none of these problems have truly gone away, the tail risks have diminished through a combination of improved economic data and political and central bank determination to do whatever it takes to avoid another crisis.  The pernicious speculation as to whether the long awaited rotation out of bonds and into equities is upon us is constantly discussed but the reality is that the market is highly concentrated on short term trading.  On good days, the headlines speak of an improving economy, falling unemployment and, in the US, the all important housing market picking up.  But market confidence is fragile and easily knocked by geopolitical events.


In 2013, investors will again have to face markets prone to set-backs as it navigates some major economic issues.  The outcome of the fiscal cliff negotiations in the US, and subsequent debt ceiling issue will probably set the tone for global stock markets until the autumn when all eyes will turn to the German elections which will undoubtedly affect eurozone, and therefore, EU policy.


The danger of a stalling Chinese economy has receded as a major concern for 2013.  The new Government handover went reassuringly well, rising commodity prices hint at a recovery in demand and the authorities have signalled an intent to provide any necessary support.


In the UK, the economy will probably continue to bump along the bottom, caught between austerity and spending cuts and will be a difficult year for the coalition to hold things together. The Chancellor, George Osborne, will have his work cut out implementing the necessary cuts to the budget and the prospect of falling tax receipts.  As in 2012, the UK’s triple AAA rating will stay under scrutiny.  The Bank of England will have a new governor, Mark Carney. His mandate will remain similar to Mervyn King and it is hard to see what he could feasibly do differently that would make a difference.  The circumstances that prevailed when he was Governor of the Bank of Canada, do not apply to the post-crisis UK economy and interest rates close to zero. We would expect that the low interest rate policy will be maintained in order to assist and economic recovery, even if UK inflation picks up above 2.7%


We continue to advocate buying of equities on excessive weakness and see short term stock market setbacks as opportunities to buy. Some investments in high quality, yielding investments will remain but we are inclined to seek better value in growth stocks ahead of the economic cycle that, we believe, will recover into 2014.  If markets shift from the short term to longer term investing based on fundamentals, we believe this strategy will be vindicated.




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