The recent policy initiatives introduced by the Bank of Japan (BOJ) are the latest in this long and bewildering chain of events as central banks attempt to offset the many and varied deflationary forces brought about by deleveraging and the accompanying austerity measures.

Having been hitherto staunchly conservative, investors are rightly stunned at the scale of Japanese QE, where the central bank has started a programme of stimulus on a massive scale.

Where the Fed may have surprised investors initially with its programme of $85bn a month, or 7% of GDP, the BOJ have trumped that with its programme of 15% of GDP, an unprecedented move. This will see it buying 1.6x net supply, completely and deliberately crowding out traditional investor and swamping the markets with further liquidity.

This has not surprisingly seen the Yen fall sharply, and has prompted a big stock market rally. The intention of the BOJ is to end 20 years of deflation and get inflation up to 2% pa by forcing investors out of bonds and into riskier assets.

It will also force domestic Japanese investors to look overseas for their returns;  with the prospects of  a non-existent bond yield, and a depreciating currency, why wouldn’t they seek a return in higher yielding foreign bond markets? Faced with a decline in the domestic population of 30%, I suspect the reflationary policies will ultimately fail, but at least the authorities are giving it their best shot.

The irony is that the underpinning this gives to risk assets feels at odds with both fundamentals, and leading indicators. Equity markets have performed well this year, but earnings revisions have turned negative and growth prospects have been downgraded, both for corporates and for sovereigns.

Within equities, cyclicals have underperformed defensives, emerging markets have underperformed the developed markets and commodities have been under pressure. It doesn’t feel like the backdrop to positive equity returns. Within Europe the recent Cypriot bailout is an additional reminder as to the fragility of the Eurozone and its financial system, and is a worrying precedent for the periphery as to what the future may look like.

Indeed, it runs the risk of undermining the banking system further by prompting deposit flight from the domestic banks. Growth appears to be difficult to come by, and the recent downgrade to growth expectations in France is the latest disappointment to hit the region.

The banking system in the US looks to be much better capitalised and well placed to fund the credit expansion required by a growing economy. Although the housing market continues to recover, the latest job statistics appear to show that growth is again slowing, in all likelihood finally reflecting the impact of the fiscal cliff impasse.

Until this is resolved, it is difficult to see confidence truly recovering, and there will of course remain the real and meaningful impact of the spending cuts and tax rises acting as a headwind to growth.

But if investors have learnt anything over the last couple of years, it is that despite anaemic growth, faced with a tidal wave of developed world QE, they ultimately have nowhere to go other than equities, not least of all because of the yield pickup offered by this asset class.

It should perhaps come as no surprise that in nearly all regions of the world, the income and higher yielding strategies have been the best performing. As long as the central bank taps are turned on I expect this trend to continue.

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Concern over the outcome of the fiscal cliff negotiations in the US caused a freeze in corporate decision-taking and spending. We anticipated a bounce back once the outlook was clearer and recent meetings with US company management teams have confirmed that this is taking place.

We have also seen companies benefiting from capital expenditure, while general corporate suppliers have seen a useful acceleration in activity. Arguments over cuts to government expenditure, known as the ‘sequester’” remain, but the effect should be over a reasonable period of time and not too material. Meanwhile, the US housing market and employment data continue to strengthen. 
 
In light of this encouraging backdrop, we have raised our forecast of US corporate earnings growth for 2013 to 9%. In contrast, we have cut our forecast for European corporate earnings for the current year to a fall of 5%. This reflects the very sluggish European economy and the impact of the recent rally in the euro on overseas earners and exporters.

The attempt to apply special taxes to depositors, as part of the Cypriot bailout, has important ramifications, both economic and political, sparking fears over contagion and depositor flight in other peripheral countries and boosting anti- EU sentiment within the eurozone. 
 
In the UK, we have made no changes to economic or earnings forecasts. Company results have been fairly encouraging, share buybacks, which enhance earnings, are growing and sterling’s weakness helps underpin our forecast of high single-digit earnings growth for 2013.

Finally, China has recently imposed new controls on the housing market to supress inflation. Whilst this will restrict growth to some extent, we expect consumption to remain robust and are confident that growth should stabilise around current levels. We expect GDP to grow by a little under 8% this year. 
  
While we see some recovery in the global economy, it continues to be a tough environment for companies to operate in and it is therefore crucial to pick the winners that can do well against this backdrop. We have identified a number of themes that we believe will help us to select the better performers.

We expect a relatively strong US economy, which should see significant benefits from likely energy independence. This favours dollar earners and US cyclical exposure in particular. We anticipate online retailing to grow further, at the expense of bricks and mortar, in a similar revolution to Walmart’s achievements in the 1990s relative to their traditional competition.

We believe that consumption in the developing economies will remain robust, benefiting consumer staple companies, retailers, banks and luxury goods companies. In Europe, our theme is to focus on strong exporters rather than domestic companies hit by the depressed economy. Finally, we expect the search for income to drive investors towards high yielders, particularly where dividends are well covered by cash flow. 
 
Towards the end of 2012 and early 2013, many of last year’s equity laggards rallied in a period of rotation as risk appetite rose. More recently, we have seen greater discrimination in performance, favouring the better-placed companies and those able to show reasonable growth. This has been helpful for our equity portfolios.
  
Our asset allocation matrix, favouring equities over bonds, has served us well in recent months. Markets are clearly vulnerable to a correction but valuations continue to be pretty attractive, quantitative easing remains on the table, corporate results have been fairly pleasing and it appears that retail investors are adding to their exposure in shares. Consequently, we retain that position.

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“We shouldn’t be surprised by this, but over the last few years the economic environment has been so extreme, we’ve become used to it dominating market returns and outcomes. Somewhat surprisingly therefore, risk assets have had a positive 2012.

“In sterling terms, equities have broadly speaking returned 10%, although the performance differential, particularly between large and mid/small cap in the UK has been more extreme than this. In credit, returns have been comfortably double digit, with the scale of the positive return being correlated with the riskiness of the credit rating. Similarly the returns for EM debt have been very strong, accompanied by very positive flows into the asset class.
 
“From a macro perspective the situation in Europe continues to worsen. The austerity measures insisted upon by Germany for the periphery have had the predictable outcome of undermining growth for the entire region. The reduction in Government spending has created an overwhelming headwind for Spain and Italy, and has reduced demand for Germany’s exports. The PMIs and other leading indicators indicate that Germany too will also be in recession imminently.
 
“In the US, following President Obama’s successful re-election, we are now in the eye of the storm of debate regarding the fiscal cliff. As has been well rehearsed, in the first quarter of next year a combination of automatic tax increases and spending cuts will reduce US GDP by about 4% unless agreement can be reached on moderating their impact.

“Our research on the ground continues to suggest that companies are using this uncertainty as a reason to defer investment spending, containing both economic and employment growth. In common with the market, we expect some form of agreement to be reached and this impact to be moderated by at least 50% but it is possible that the political deadlock takes the US economy over the cliff and into recession for 2013.
 
“Against this backdrop it may be surprising to hear that we are becoming increasingly more constructive towards equities and have gone moderately overweight, initially increasing our weighting in EM and Asia Pac. Indeed if the markets continue to be unsettled by the situation in the US we will use the market weakness to increase our equity exposure further. The key driver to our decision is valuation and what is currently discounted.

“Although the backdrop remains very challenging, it is not new news and in many respects we are closer to a resolution of the uncertainties. This is clearly true of the US, but also of Asia, where the regime change in China is now largely effected. In Europe, investors probably face crisis fatigue and an unexpected negative outcome is becoming increasingly unlikely.

“What is true is that against this backdrop, interest rates are going to stay close to zero for the medium term and high yielding equities are likely to remain well supported. Other valuation metrics remain attractive, and the robust balance sheet strength is another positive. Although not our central case, it is just possible that we get a positive growth surprise in the global economy in the second half of 2013. If that is the case, equities will start next year with significant positive momentum. Now that would be a turn up for the books!”

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We continue to expect that the economic outlook will be difficult and that the overhang of debt will cast a very heavy shadow for an extended period. However, we believe there may be a few grounds for expecting some improvement in the near future. In the US, there have been a number of economic surprises on the upside and the housing market appears to be showing a useful recovery, even before any beneficial impact from the Federal Reserve’s recently announced QE3 policy, which is aimed at lowering mortgage costs.

While the earlier uncertainty over the outcome of the US presidential election has now been resolved, and President Obama is back in the White House, the fiscal cliff continues to cause concern and has led to the postponement of investment decisions. We expect more details of measures to tackle the fiscal cliff shortly, and this may release some pent-up demand in the more predictable environment that should follow. 

Meanwhile, the news from China shows signs of the economic slowdown having bottomed. The latest purchasing manager’s index of manufacturing activity was above 50, indicating expansion, and the recent destocking phase appears to be largely over. In addition, the leadership transition is underway and this could lead to some stimulatory activity by the new administration.

We also have generally lower than consensus forecasts for corporate earnings growth. Whilst the current reporting period has been a fairly mixed one, with a higher percentage of disappointments than we have seen for some time, the pace of downgrades to forecasts appears to have slowed.

Another of our long-held views has been a strategic underweighting of bank shares. This month we undertook extensive in-depth analysis of the sector and concluded that the ‘tail risk’ scenario of wide-scale failures had largely passed and that the sector would perform more in response to regional conditions rather than as a global group.

The situation in the US is increasingly positive, with relatively robust balance sheets and a recovering housing market. The outlook for the UK and Europe is less encouraging with further balance sheet adjustments required and a sluggish economic background. Emerging economy banks appear fairly well placed in light of economic expansion and lowly-leveraged consumers.

On balance, we are more constructive on the sector, but there are still significant issues and the local situation and stock specific factors will be increasingly important for performance.

Elsewhere, we expect the search for income to continue, which will be beneficial for higher yielding bond classes and for companies with high, well-funded dividends. The yield on equities, combined with the likely impact of quantitative easing around the globe, should act as a support for shares.

However, opposing this are the risks from the eurozone, the fiscal cliff and the difficult economic background, which leads us to adopt a neutral position on equities. We are cautious on UK commercial property despite a reasonably attractive yield; demand is weak and a huge refinancing operation needs to be undertaken.

We expect commodity markets to be pulled in different directions, with quantitative easing most likely to benefit precious metals. We see tight supply conditions in the oil market, and a shock to production cannot be ruled out given Middle East tensions. However, buoyant agricultural markets will lead to heavy planting, which may limit future gains. Furthermore, the sluggish global economy and the shift in China from investment-led growth towards greater emphasis on consumption are negative for industrial metals. We have a neutral view on commodities overall.”

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