risks quicker than speed of global recovery

Yet we remain aware of the various risks and cannot ignore that, for instance, the recent economic data from the US and Japan has been slightly weaker than expected so far this year. In addition, conditions in many of the largest emerging markets remain fragile following sharp currency falls in January and further investment outflows. 

The US and UK look likely to experience the highest growth rates in the developed world due to the pick-up in private consumption, falling rates of unemployment, lower household debt burdens and higher asset prices.

In the US there should also be fewer spending cuts in the public sector, while cash-rich companies have room to increase capital spending and investment. We believe the recent weakness in economic data is temporary owing to severe winter weather.

 

Figures for the fourth quarter of 2013 revealed that the eurozone’s economy expanded at a faster rate than expected, supporting our view that conditions throughout the region are also improving. Notably, the recovery is being driven not only by the northern economies but also peripheral countries – and France where weakness has been a concern.

 

Meanwhile, the pace of growth in China looks set to slow a little further this year. Given the elevated demand for credit, the authorities are likely to continue to tighten monetary policy. Yet despite the additional problems in many other large developing countries, we expect the overall economic situation to stabilise across emerging markets as the global recovery continues.

Although equities remain the most attractive asset class in most scenarios, valuations are starting to look stretched, particularly in the US:

• Abundant liquidity and repressed interest rates in our “muddling through” and “economic renaissance” scenarios continue to support the markets; 

• Improved earnings prospects in our “economic renaissance” scenario should also boost equity prices despite the prospect of higher interest rates;

• This pattern applies particularly to the US market. It is the most overvalued region but equity prices could continue to rise if our “economic renaissance” scenario becomes increasingly likely.

• We are avoiding long-maturity nominal bonds because they would be negatively affected by a return to more normal monetary policy in the “economic renaissance” scenario;

• Within fixed income we continue to like shorter-maturity corporate bonds. This part of the market has two attractive features. First, there is still a decent yield advantage relative to government bonds. Second, the short maturity offers some protection against rising interest rates.

• The still sizeable probability of our “new monetary world” scenario lies behind our ongoing exposure to real assets such as gold, real estate and possibly inflation-linked bonds; 

• We are also confident that over an economic cycle equities continue to offer protection against inflation;

• Additionally, we are focusing on hedge funds that have the flexibility to adjust to an unexpected rise in inflation.

• We believe our “depression” scenario is the least likely but its impact would be so disruptive that it must be considered within our investment strategy. Although equities remain the most attractive asset class, they are vulnerable to stretched valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero;

• Therefore, we include hedging strategies that can limit the potential losses from our portfolios if the equity markets suffer a material correction;

• We have a sizeable allocation to hedge funds that can provide significant protection in a bear market or which are not affected by adverse movements in equity markets and therefore provide true diversification;

• Additionally, we have direct equity hedges usually in the form of out-of-the-money put options on broad equity indices.