Market outlook

In our view, global real GDP growth will slow to between two to three percent in 2012, with respectable progress in the US and emerging markets being partially offset by recession in Europe. We expect ultra-low interest rates to remain a feature of financial markets for a few more years, as central banks continue to lean against the deflationary impact of austerity, and the risk that the financial system could again become stressed by the weight of unresolved debt problems in many countries. On the corporate front, we expect that profits will continue to grow in most regions, with emerging market companies outpacing the rather more pedestrian progress we anticipate from those that have a greater dependence on developed market economies.

The success of the long-term refinancing operation (LTRO) in Europe, combined with the agreement of a second bailout package for Greece, has gone a considerable way to easing the immediate systemic risk apparent in the European banking system in 2011. Time has been bought to further shore up defences. However, there are still many risks to our base case macroeconomic view as described above. For example, the European debt issue could quite conceivably reignite itself, notwithstanding the calming effect that the success of LTRO has so far delivered. Equally, our base case expectations could also be knocked off course by any significant escalation of tensions in the Middle East, as this could lead to a spike in the oil price with negative effects on inflation and growth. In addition, uncertainty could be created by elections in France and the US, as well as central bank rhetoric vis-a-vis future monetary policy, or quantitative easing.

But while we live in a world where the economic outlook is more clouded than normal, there are some very rational reasons for investors to travel with a good degree of hope. The key point here is that even though equities and financial risk assets have bounced strongly from their 2011 lows, absolute valuations still remain quite undemanding. In the case of equities, many markets around the world trade on price earnings ratios in the range of 10 to 12 times, which is typically three to four points below established norms. Elsewhere, in fixed income, while yields on creditworthy government bonds are at extreme lows (indicating they are very expensive), spreads on investment grade corporate bonds and high-yield debt are close to twice as wide as was regarded normal prior to the onset of the financial crisis in 2007/2008 - indicating that these offer good value relative to government bonds.

In this environment, we should not expect any quick solutions to the fundamental problems created by excessive debt levels. Adjustment through austerity measures will take time and constrain growth in developed economies for a number of years. Even so, we believe that at current valuations, investors should be prepared to take on some risk within their investment portfolios, although our approach will continue to balance the attraction of these valuations, with an expectation that volatility is likely to remain above normal.