Increasing signs of improving global growth and continued strong central bank commitment to highly accommodative monetary policy indicates that the first part of next year has the potential to be a good one for cyclical and risky assets.
In this environment, commodities could perform well as an asset class, with more growth-sensitive commodities such as base metals and the white precious metals having the potential to perform most strongly.
Within equities, basic resources and mining companies could outperform. Commodity currencies such as the Australian, New Zealand and Canadian dollars may rise in this environment and, barring a major sovereign debt-related accident, the Euro should benefit. Conversely, funding currencies such as the Japanese yen and the US dollar may come under pressure.
The three key risks to this benign global scenario are a sharp rebound in sovereign risk in Europe – Greece and Spain in particular; the US fiscal cliff issue and possible US sovereign downgrade; and further political and military deterioration in the Middle East. Long gold, oil and volatility positions are potential hedges against these risks.
Global growth is recovering . . .
As we near the end of 2012 and look into 2013, there are increasing signs that the global economy is starting to recover.
While the recovery is uneven and there are a number of large potential tail risks that can derail it, lead indicators point to an upturn in the global economic cycle. Europe, particularly the periphery, has been left out so far, but the US and China, the two main engines of global growth, are now showing clear signs of recovery.
. . . and developed economy central banks are targeting higher asset prices
At the same time, the world’s major developed economy central banks are committed to maintaining low interest rates and providing extraordinary amounts of liquidity to the world’s financial system.
As the US Fed has made clear in its last two statements, the commitment to low interest rates and the provision of large and regular amounts of liquidity goes beyond short-term crisis prevention policy and will remain in place for a “considerable time” after the economic recovery strengthens.
This stated commitment, together with hints that additional liquidity will be provided in the new year as “operation twist” comes to an end, indicates that the Fed is actively encouraging investors to take more risk and trying to stimulate a sustained rise in asset prices.
Normally, an environment such as this – an upturn in the global economic cycle and highly accommodative monetary policy – would be strongly positive for cyclical and risk assets. However, so far, these types of assets have shown only muted performance, with sporadic sharp rallies often followed by equally sharp corrections.
But high risk of policy mistakes
A likely explanation for why cyclical and risky assets have not performed more strongly is continued investor concern that the positive growth and liquidity environment will be disrupted by policy mistakes – either by the US Congress driving the US economy into a self-induced recession (and ultimately another credit downgrade) by allowing the US to go off the “fiscal cliff” at the end of the year, or gamesmanship by Europe’s politicians leading to a policy mistake that potentially sends Greece out of the Euro and/or invites a renewed sense of panic about the outlook for peripheral European sovereign debt and banking systems.
Until the US fiscal cliff issue is resolved, it is likely that cyclical and risk asset performance will be constrained and remain closely tied to changing perceptions of the likelihood of compromise solutions being found.
Bias towards cyclical assets and key risk hedges
On the assumption that ultimately the fiscal cliff issue is resolved (or at least postponed beyond most investors’ immediate investment horizons) and Europe’s worst problems are kept at bay, the first part of 2013 may be a good one for more cyclically-geared assets.
However, recognizing that US fiscal, European sovereign, and Middle East political risks remain high, it is expected that most investors who increase cyclical weightings will want to maintain a bias towards quality assets and hold hedges against worst case scenarios.
Against this backdrop, how do we see investors positioning themselves for 2013?