We believe that the market has scope for further upside this year but are doubtful it can continue to rise strongly in the short term.
The style of exposure is as crucial as pure asset allocation, just as it was in 2011, correlations are moving lower and the dispersion in returns for 2012 will be considerable.
The wild card is still Iran. The risks are rising, and higher oil price is a drag on growth and an inflationary factor. On the plus side, if we get a pre-US election dip in markets between now and the summer then this would fit the historical patterns, and be a sound entry point.
Bull points
Macro:
The European crisis has seemingly slipped away from market’s concerns. Central banks are squarely behind risk assets across the globe and this will not change in the foreseeable future.
Equities:
The strong performance from markets has continued, especially the laggards of 2011 including mid and small caps, and emerging markets. Sentiment seems set on a good year and we are reminded of the 2002/03 turning point in markets.
Corporate activity is on the increase; companies have the ability to use their cash to build or buy (the latter we suspect). On the whole, we’ve witnessed decent US earnings and as expected, European earnings underperformed.
In the UK, some retail names are worth buying and we favour mid cap oils on a stock specific basis. In the US, technology and healthcare remain attractive. Valuations are supportive in emerging markets, especially Brazil.
Corporate bonds:
There is now a good opportunity to sell high premium sterling-denominated, CGT-qualifying bonds and switch into new issues. The European LTRO has reduced the risk considerably in the financials sector, presenting opportunities with €1trn of liquidity in the system.
Bear points
Macro:
The risk asset rally has become extended and equity markets have become overbought in the short term. Risk appetite has increased substantially and there are signs that optimism is creeping towards extreme levels.
Equities:
The pull-back may not be material, but committing capital at these price points is tough and we believe prudence is required. In emerging markets: we are also seeing some soft data in commodity and trade statistics that warrant some caution in Asia.
Government bonds:
Further QE in Japan, UK and Europe maintains a wholly false market for these securities. We favour zero exposure, and would look to short gilts and US Treasuries on strength.
Emerging market fixed income:
Some Asian markets, such as Korea, Indonesia and the Philippines, look overbought. This suggests to us that plenty of good news is factored in to prices here and even emerging market sovereign paper has market beta, therefore as per our overall view we would add on weakness.
Our conclusion
While we retain a positive outlook for most risk markets and in particular equity markets for 2012, in the short term we need a retracement or consolidation at these levels.
