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US and Developed Markets

The New Year brings new challenges and yet many of the problems from the past three years remain unsolved. The year of the Dragon signifies wealth and prosperity. Let’s hope that this signifies a turning point in economic fortunes!

This year is going to be characterised by continued volatility in both the debt markets and the equity markets. While there is an underlying current of optimism that the debt crisis in Europe, specifically Greece and to a lesser extent Portugal will be resolve by the middle of this year there is still the risk that contagion takes a grip on the other European countries. Recent downgrades of European Sovereign debt continues to create uncertainty and fear. This could well be the pattern for the year. Optimism from the equity markets, politicians, and economists create positive momentum, only to be deflated by the realities highlighted by the rating agencies and the needs of the debt markets. The majority of western economies are currently hooked on some form of QE, be it in the UK and the US with classic QE and now the Eurozone with the recent 3 year LTRO, (long term refinancing operations), launched in December with a second instalment due in February. Short end rates and the market's expectations of short end rates are being kept right down for now with the German 2 year Bobl yielding 0.18%, UK 2 year Gilts at 0.36% and US Treasuries at 2 year 0.21%. Just this week, the Federal Reserve confirmed its intentions to keeps rates down with a horizon of 2014 unless significant developments change their outlook. It is worth bearing in mind that despite these easy monetary conditions, the IMF cut its forecast for global growth from 4% to 3.3% this week, testifying to the still broken monetary transmission mechanism and the likely impact of austerity measures shaping up in the UK and Europe in particular.

The January Effect has continued with full force with markets squeezing up aggressively as market participants grab breathlessly to add risk. Market perception has certainly changed markedly in the past two weeks with scepticism capitulating to optimism, for the US market it has been the strongest January since 1994. To put this in context most equity markets had a bad year and a bad December quarter. The Australian market was down 11% for 2011.

US consumer confidence declined unexpectedly in January, due to deterioration in the assessment of current conditions. The Chicago purchasing managers' index also softened in January. Case-Shiller home price index declined more than expected in November (-0.7% vs -

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0.5%), while the employment cost index rose. EU leaders on Jan. 30 held their 16th summit in the two years since the Greek debt emergency provoked a Europe-wide crisis, leading to aid packages for Greece, Ireland and Portugal. Greece pledged a last-ditch effort to prevent the collapse of its second rescue package from creditors, aiming to complete talks this week on a financial lifeline that’s been in the works for six months.

Australia The equity markets remain range bound as sentiment about the prospects for growth in our economy turn pessimistic. Australia looks to have achieved 2 per cent growth in calendar 2011, driven by mining-related investment and a household sector that is gradually growing in confidence. This is despite the headwinds of a high Australian dollar, the floods at the beginning of the year, tightening of Government spending, and ongoing economic turmoil in Europe and the United States. Non-mining profitability, having largely tracked sideways for three years, now also appears to be recovering. But employment growth remains anaemic. Final demand is extremely strong in Western Australia and Queensland, but remains insipid elsewhere. The International Monetary Fund has reduced its forecasts for economic growth in Australia this year from 4% to 3%.

The yield curve is now comfortably inverted which historically has been viewed as an indicator of a pending economic recession. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.

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Emerging Markets Chinese manufacturing indexes rose in January as the world’s second-biggest economy withstood weaker exports driven by the euro-area debt crisis and a government-induced property slowdown. The official purchasing managers’ index increased to 50.5 from 50.3 in December, a reading below the 50 level that divides expansion from contraction. Tighter monetary policy, weaker export demand and jittery international investors combined to make emerging markets equities one of the worst-performing asset classes in 2011, however Emerging-market stocks posted their best start to a year since 2001 after European countries agreed to tighter budget controls and as policy makers from Brazil to the Philippines cut borrowing costs to spur growth. Investors started the year going long on emerging market currencies, expecting them to outperform comparable developed market nations that are burdened with debt.

Summary

Our recommendations are;

1. We are still favouring debt products over equity products. 2. Despite the concerns over the credit sector there are opportunities in high yield, Bank loans and distressed debt. 3. Non directional strategies with low beta still look attractive in managing the equity market volatility.