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Looking ahead

Despite the improvement in sentiment towards markets, it is clear some very significant risks have not abated. The threat from unsustainable fiscal deficits continues to be very real and, despite the EU-lead rescue plan for Greece, bond investors remain unconvinced and have pushed yields higher. On a wider view, however, the relative equanimity of Western sovereign debt markets has not yet put enough pressure on governments to cut deficits and this has becalmed equity markets, leading to the sense of crisis receding. Will policy-makers lead markets, or are they waiting to be led – if it is the latter, this complacency could prove very, very damaging.

In assessing how our portfolios should be structured, we have spent time reviewing the likely course to be taken by the global economy and risk markets over the next 12 to 18 months. In our view, there are three likely outcomes, which we have summarised below:

Scenario 1: Sub-par, two-speed recovery

In the developed world, economic recovery is tepid and sub-trend. This allows the financial system to rebuild slowly as the household sector continues to deleverage and credit demand is weak across the corporate sector. US unemployment remains stubbornly high and the housing sector depressed. By way of contrast, emerging market economies enjoy a strong cyclical recovery which continues to drive global growth going forward. These economies are well-placed to benefit from a strong mix of loose monetary policy, commodity strength and improving domestic demand from consumers with no debt overhang. Equity returns are positive driven by profit growth, although the easy money from the rebound has already been made. Credit spreads remain narrow while government bonds are supported by investor demand and the possible resumption of quantitative easing measures.

Scenario 2: Hard times ahead

A period of economic stagnation prevails with the burden of excessive fiscal deficits, escalating national indebtedness and negative wage growth engulfing Western governments and consumers alike, triggering a prolonged deflationary spiral. The catalysts for this outcome will likely be policy errors centred around interest rates, fiscal tightening and cuts in public expenditure. An extended period of little or no growth will put downward pressure on corporate earnings and unemployment levels will remain elevated. Bond market volatility, caused by funding difficulties will unsettle investors and risk aversion will return. Consumer confidence in the developed economies is likely to retrench and demand falls to such an extent that emerging market economies are unable to sustain forecast growth levels. Equities, credit and commodities suffer and are volatile - cash and gold are the only safe havens.

Scenario 3: Global recovery

A synchronised global recovery gathers pace, with the upturn as steep as the downturn – a V-shape. Policy stimulus leads to a surprise fall in US unemployment which supports the housing market and consumption. The emerging market economies resume export led growth and corporate profits across the West and the East beat expectations, supporting a continuation in the equity rally, with periodic volatility on rate hike fears. Inflation risks escalate and government bond markets endure a significant sell-off. Commodities perform strongly.

Based on a consensus view, we believe the probabilities attached to each of these are 55% for scenario 1, 30% for scenario 2 and 15% for scenario 3. On this basis, we will continue to carry a bias towards emerging equity and debt markets but, as mentioned earlier, will seek to capture opportunities in developed markets too. We will not discount the probabilities attached to scenarios 2 and 3, particularly 2 as this will have very significant implications for investors for a number of years to come.

We have regularly concluded in recent quarterly reports that the outlook is challenging and it was important for us to remain cautious as trusted stewards of our clients’ capital. By applying probabilities to what we see as the most likely market outcomes, we hope our clients have been given a useful insight into our process and how this thinking has shaped our current portfolio strategy.