As some wag said, ‘the trouble with the future is that it is difficult to predict’. So for 2013, there will be a few certainties, a number of probabilities and a myriad of possibilities, which will no doubt all conspire to blow our expectations out of the water, but here we go.
The one certainty that we can be confident about is that the outlook for the European economy will remain gloomy. The US fiscal cliff, high levels of deficit and debt in Europe, austerity and social unrest provide the back cloth and much of Europe will flirt with recession in 2013. This could be further complicated by Greece leaving the eurozone, tension in the Middle East surrounding the Iran nuclear facilities, uncertainty over the outlook for China under the new premier and possibly tension in the ominously pricy bond markets.
Whilst we can take some comfort that governments and central banks are throwing everything at the problem via quantitative easing, this is unconventional policy, which may prove finite. So the maxim for investors should be, ‘don’t rely on the economy to bail you out’.
That said, it is my firm belief that markets can continue to grind higher. Bull markets are supposed to climb a wall of worry and whilst there is plenty to worry about, valuations remain supportive for equities in terms of cash flows, price earnings ratios and dividend yields.
In particular, it is the combination of free cash flow yields and balance sheet strength which gives me confidence about the outlook for the stock market. It is not uncommon to find high quality businesses giving free cash flow yields of over 8% with well covered dividend yields of over 4%.When interest rates and government bond yields are near all-time lows, this is highly attractive for investors and corporate buyers.
The bleak top-down view leads investors to continue to favour defensive high quality blue chip equities and to avoid high risk, high leverage and cyclicality. However, the classically defensive areas, where investors have ‘hidden’ over the past few years, now look like an expensive crowded trade. I think it will be the second derivative of defensiveness (companies such as BT, Dairy Crest, Reed Elsevier, and Informa), which will perform better in 2013 – resilient businesses, but on substantially cheaper ratings.
There are still plenty of opportunities around for investors to benefit from sensible bottom up stock picking. 2013 could easily be the year for equity income, as despite all the bullish talk about the sector, current valuations do not reflect the optimism.
Chris White is the manager of the Premier Income Fund