The re-election of President Obama maintained the political status quo as its fiscal cliff negotiations began. After several heated weeks of debate, agreement was reached at the turn of the new year between Democrats and Republicans. It was voted to enact around $600bn of revenue gains over the next ten years from higher taxation, particularly on upper income households.
However, we see this agreement as a good outcome but no grand bargain. Debates around sequestered spending cuts and raising the US debt ceiling were postponed until Budget discussions open in February.
Global equities rose 3% in dollar total return terms. US equities (-0.2%) lagged European equities (7.1%) over the quarter in dollar terms. UK stocks were up 4.2% over the quarter. Emerging markets (5.6%) outperformed developed markets (2.6%), as better activity data and stronger domestic demand drove developing economies’ equities higher.
At the global sector level, financials (+8.5%) was the best performing sector over the fourth quarter, telecommunication stocks the worst (-4.7%). In general, higher beta sectors outperformed more defensive ones. Over the year as a whole, global equities rose 16.8%, with nearly all countries posting gains on the year.
At a sector level, financials were the strongest performing global sector (29.4%) with other cyclical sectors also rising strongly. However, energy (3.1%) was a notable laggard of this trend, underperforming all other sectors over 2012.
In fixed income favourable policy developments led to strong rallies in the more cyclical elements of global bond markets. European high yield bonds rose 9.1% and US high yield returned 3.2% over the quarter. Peripheral European sovereign bonds in Spain (8.2%) and Italy (7.7%) also performed well, supported by actions in Greece. Core sovereign bonds in the US and UK were broadly flat over the quarter (-0.1% and 0.3% respectively) as investors began the slow rotation out of overpriced safe havens.
Flows into higher yielding corporate credit also increased over the quarter. In the UK inflation-linked bonds (6%) outperformed conventional bonds as the Bank of England raised its medium term inflation forecasts. Over full year 2012, high yield bonds in Europe and Italian sovereigns led fixed income markets higher (29.2% and 22.9% respectively).
While investment grade debt in the US (10.4%) and Europe (14.8%) posted strong 2012 gains, we do not expect that 2013 returns will be as high, given the low level of spreads over government bonds now present in corporate high grade markets. Emerging market local currency bonds posted solid gains of 18.4% in 2012.
In currency markets, the Japanese yen fell 10.1% against the dollar over the quarter. Over the year, the Japanese yen weakened by 11.3%. This move was driven by the election of Shinzo Abe and an expectation that the Bank of Japan would engage in more aggressive moves to ease monetary policy, so weakening the currency. The euro strengthened 2.6% against the dollar but strengthened 2% against sterling over the three months to end December.
Sterling rose 0.5% against the dollar over the same period, as Bank of England monetary policy stayed on hold. Sterling was 4.6% stronger over 2012, while over the same period euro’s appreciation against the greenback was more modest (1.8%). We expect that the dollar may strengthen against the euro and the Japanese yen in 2013, as growth differentials favour the US economy and dollar-denominated assets.
Commodities markets lagged other growth-sensitive assets during the fourth quarter, as the global manufacturing cycle still showed signs of pressure. The Dow Jones UBS Commodity Index, a broad measure of commodities markets, fell 6.3% over the period. Precious metals such as gold (-5.5%) and silver (-12.2%) gave up strong gains despite continued monetary expansion from the Fed and the Bank of Japan.
In 2012 as a whole, the best performing commodities were agricultural. Wheat rallied 19.2% and soybeans 18.4% over the year, as poor weather in the US and South America squeezed global yields and pressured inventories. Divergent supply conditions in the US and the Middle East led to Brent crude oil rising modestly in 2012 (3.5%) whereas the US benchmark (West Texas Intermediate or WTI) fell 7.1% over the same period.
So what does the year ahead hold for global markets?
Our view for 2013 is that highly supportive global monetary policy in 2012 will begin to translate into better economic growth in 2013. We see the fiscal cliff as causing a modest drag on growth but not derailing the gradual recovery. Eurozone economic growth will remain lacklustre but begin to stabilise towards the second half of 2013.
The coming year will see greater opportunities, in our view, in equities rather than fixed income, especially core sovereign and investment grade bonds. Drivers will likely be favourable policy, economic momentum and relative valuations.
Within equities, we favour higher beta markets such as Europe and emerging markets. We continue to favour income-generating equities in 2013, especially those with growing dividends.
As Japan’s election results increased the likelihood of further monetary policy easing, Japanese equities rallied and the Japanese yen materially weakened against the dollar
Macro overview
- The fourth quarter of 2012 saw a number of significant political and policy events that drove global risk assets, such as equities, higher;
- Agreement between Democrats and Republicans on the US fiscal cliff was reached – however, we believe that the extent of the agreement is a good outcome but no grand bargain;
- Europe remains beset by recession but stabilising data and the disbursement of loans to Greece offered some support to peripheral European assets;
- Elections in Japan increased the chances of more accommodative monetary policy; China’s economic data releases suggest that the nation has passed the low point in its growth cycle.
Our Themes
- Short-term (first quarter 2013): we look to add to equities, especially higher beta markets like Europe and emerging markets, on any market weakness;
- Longer-term (first half of 2013): we believe that investors should avoid potential overheating in selected fixed income markets (notably investment grade) as global growth improves.
