2012 promises a rough ride for investors. Much of the industrialised world is engaged in a deleveraging process which will take several years and have negative consequences on economic growth. As a result, the global economy is extremely fragile and it won’t take much to trigger a major crisis. After 2008, the authorities tried to stabilise the situation using unprecedented fiscal and monetary stimulus measures, but in so doing, they merely delayed the outcome while aggravating the problem of excessive debt. Furthermore, the resulting massive deterioration in the public finances means that the risk of a systemic crisis is now much greater than it was 3 years ago.

The situation in the eurozone is particularly worrying. Within the eurozone, there is too much debt, too little growth, and the current-account imbalances are too excessive. This crisis is a particularly dangerous mix between a banking crisis and a public debt crisis with an undercapitalised banking system holding a large part of its assets in government bonds of overly indebted countries. This latter point also means that the European banks’ recapitalisation requirements cannot be known until the eurozone government bond market stabilises. And until these requirements are known, there will be no return to confidence in the European banks. With massive refinancing requirements, the banks will try to trim their balance sheets by shedding assets and reducing lending. This will be an additional brake on economic growth, already hampered in many countries by fiscal austerity. In short, the global economic situation is in danger of almost grinding to a halt just when the authorities have essentially exhausted their monetary and fiscal resources.

In the face of this distinctly worrying prospect, investors are entitled to want better remuneration for buying financial assets. But the opposite is happening. In recent years, the monetary authorities have done their utmost to avoid the necessary structural adjustments while at the same time maintaining artificially low interest rates. They have thus promoted a tide of speculation to the detriment of saving and productive investment. With a near-zero return on money market investments, with quality (or at least perceived as such for now) government bonds in some cases offering negative yields on short-term placements and below 2% on long-term maturities, and investment grade corporates scarcely better, the possibilities open to investors seeking regular income and trying to avoid huge fluctuations in the value of their portfolio are not very appealing. 

So what’s the position for the stock markets? Although most equity markets fell in 2011, it would be unwise to think that the risks outlined above have already been factored into share prices. Especially as the US market, which generally sets the tone for the other markets, did not see a correction in 2011; based on normalised profits, it is still richly valued. The cycle of rising margins is coming to an end, and with it, that of regular better-than-expected profits. With the appreciation of the dollar, the S&P 500 also looks to be losing a vital support mechanism given that foreign sales account for nearly half of total sales of companies in this index.

By comparison, the European markets appear rather more attractive. However, this idea needs to be put into perspective. The view of Europe as cheap is based on the composition of the European indices, which are heavily weighted in favour of cyclical and financial stocks. But in the current eurozone crisis context, it is impossible to value the banks. And at the same time, shareholders in some of the banks could be sharply diluted in the event of a major recapitalisation, or complete losers in the event of nationalisation. For their part, cyclical stocks are obviously heavily exposed to any deterioration in the global situation. The cyclical nature of their results also means that they will always trade at a discount against more defensive stocks, yet these more defensive stocks are no cheaper in Europe than in the United States.

The period of convergence between European market valuations also seems to be over. Since the introduction of the single currency, the price/earnings gap between the most expensive and the cheapest markets in the eurozone has halved. With the structural weaknesses of the single currency becoming evident in the current crisis, there will continue to be high interest rate differentials between eurozone countries and this will have consequences on the economic performance of the member countries and the valuation of their stock markets. This does not augur well for the markets of Southern Europe.

As far as stock market valuations are concerned, it is worth noting that although it is obviously useful to compare current valuations to historic averages, it is also important to have an idea of the framework in which we will be evolving. Financial history shows that while US equities have traded on average at 15x profits over the last 100 years, this figure is only an average between long periods when their valuation was considerably below this figure and long periods when the valuation was a lot higher.

At the end of the last bull market in 2000, valuations were historically high. Since then, they have been on a downward trend. This trend is likely to continue given that:

- unlike the last 30 years in which increasing debt stimulated economic activity, the deleveraging process will dampen it. With less potential for profit growth, investors will pay less for these profits;

- in the coming years, we are likely to see shorter economic cycles and more frequent recessions. Corporate profits will be more volatile. Financial history shows that there is a negative correlation between earnings volatility and the valuation multiples accorded to these earnings;

- the increase in multiples during the 1980s and 1990s was mainly due to the fall in interest rates as inflation receded. Interest rates are currently at very low levels. Rather than reflecting a particularly brilliant economic environment, this is due to a host of structural problems. If interest rates fall further, it will be because Europe and the United States have entered a Japanese-style scenario, but with considerably less social cohesion. The experience of the Japanese market in the last 20 years shows that there has been a positive correlation between interest rates and equity valuations, the latter declining along with the former;

- in recent years, companies have been the prime beneficiaries of the fruits of economic growth. As a result, corporate profits are capturing a historically high share of national income. This trend cannot continue;

- the end of the Cold War sustained valuation multiples in the 1990s. Today we are seeing a new wave of geopolitical risk.

By contrast, the Japanese market is genuinely undervalued. Companies in the Topix index are trading on average below their book value and it is possible to find a good many companies whose stock market capitalisation is less than the net cash they hold. As is generally the case with an undervalued stock market, no-one is currently showing any interest in the Japanese market. While it is true that in the context of a slowdown in the global economy, investing in a market generally considered as cyclical is not the first thing that springs to mind, in Japan’s case, the potential for decent long-term returns (due to its low valuation) would at least compensate the investor for the risks incurred.

Price-to-book ratio on the Japanese market

 

 

The last year has confirmed that the emerging markets are not only correlated to other markets, but that their volatility is even comparable to that of the more cyclical sectors in Europe and the United States. This is hardly surprising given that exporters and commodities feature prominently in most of the emerging indices. A slowdown in the global economic situation and appreciation of the dollar will not be beneficial to these sectors. On the positive side, the easing of inflationary pressures should enable the authorities to relax their monetary policy.

In the current context, it is important for investors:

- not to allow themselves to be influenced by short-term fluctuations on the financial markets. These fluctuations are the result of the interaction between the authorities’ interventions and the poor fundamentals;

- to worry about what they hold in their portfolio, not about what they don’t hold. Concessions should not be made on the quality of the assets held, even if these assets temporarily underperform;

- to wait, if possible, for better buying opportunities to arise;

- to avoid creating a rational argument for the positions they hold that they don’t want to sell.

Based on all this, our investment recommendations for 2012 are:

• buy high dividend shares of non-cyclical companies:

in the current environment, stable quality income is becoming rare and something that is rare should be in the portfolio. Demographic trends also support strategies for producing regular income. Companies paying decent regular dividends should benefit. Given the risks hanging over growth, companies whose activities are very sensitive to the global economy should be avoided;

• buy assets that will be considered as safe havens in the event of a downturn in the economic and financial situation:

the past has shown that when aversion to risk increases, the US dollar benefits. Despite the many problems in the United States. the dollar continues to be the reserve currency which investors flee to when they are fearful. Especially in an environment in which the future for the dollar’s principal alternative, the euro, is uncertain to say the least.

In a context in which confidence in paper money is wearing thin, gold remains the ultimate safe haven for many investors. Its bull run seems set to continue, notwithstanding temporary corrections such as that at the end of 2011. Also, note that the central banks of emerging countries are continuing to buy gold. If the price of gold holds up or continues to increase, shares in gold-mining companies are undervalued, especially if these companies continue to demonstrate better financial discipline than in the past.

The government bonds of countries that continue to retain market confidence will also profit from structural economic weakness, despite the current very low level of long-term interest rates. The 30-year US rate could return to its end-2008 level in 2012. If this happens, the potential yield on a 30-year bond would be well over 10%. However, it is important to emphasise that the volatility of such an investment could be too great for a traditional bond investor;

• take advantage of corrections to increase the weighting of assets with good medium and long-term prospects:

It is sometimes helpful to bear in mind that the major trend marking the 21st century economy is that the East will steadily overtake the West as the driver of the global economy. In general, emerging countries have better economic fundamentals and more favourable growth prospects. Their stock markets should therefore occupy an increasing portion of a diversified portfolio. Since the stock markets of these countries are generally ‘high beta’, meaning that in the short term they tend to amplify the movements of industrialised markets – up or down – attractive purchasing opportunities could arise during the year.

US, European and emerging markets over the last 10 years (in euros)

 

Note that fears of a pronounced economic slowdown could also temporarily weigh on the currencies of some countries even though their fundamentals are better. Apart from emerging currencies, the Australian and Canadian dollars and Norwegian krone are often considered cyclical. Corrections in these currencies would constitute buying opportunities for the longer term;

• buy shares of multinational companies active in defensive sectors:

the financial situation of these companies is generally excellent and in an environment in which government public finances are deteriorating, their shares could replace many countries’ sovereign bonds as preferred assets in the portfolios of institutional investors. Note that these companies often pay attractive dividends and realise a growing proportion of their earnings in emerging countries;

•  avoid heavily indebted companies and countries:

high debt is an enormous problem in an environment marked by low growth and deflationary trends. Furthermore, in the current year, governments and banks have massive refinancing requirements. Non-financial companies are in danger of losing out in such an environment;

•  avoid very cyclical assets;

•  avoid banking stocks.

Finally, long/short strategies aiming to buy quality assets while hedging part of the market risk make a lot of sense in the current environment.