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A dangerous cocktail

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Loose monetary policy mixed with fiscal authority could bring side-effects which are difficult to foresee

Markets were fixated by short-term events in 2011, creating significant stockmarket volatility. We believe that for those investors prepared to take a longerterm investment, this creates some potentially attractive opportunities for 2012 and beyond.

Amid the uncertainty, many investors flocked to “safe havens”. As a result, the gold price reached record highs and core government bond yields collapsed to the lowest levels for a generation, putting them in a position where returns were negative when inflation was taken into account. Based on this, we believe equities offer some of the best value in 2012, even though short-term performance is likely to remain volatile but investors should remember that many firms are in solid financial shape, with many having put in place their own cost-cutting measures.

We feel economic growth is likely to remain under pressure this year and we continue to see stronger growth from global emerging markets in 2012 in comparison with the developed world, albeit that the rate of growth may slow somewhat compared with recent history.

While many European companies have robust finances, a lack of confidence has put them off investing. But we feel this ignores two key positive factors - first, many companies based in the Western world are increasingly benefiting from profits in emerging markets and, second, while the macro outlook for developed markets may continue to be difficult, emerging market equities look set to benefit from a much more supportive economic environment.

We believe as emerging markets continue to grow, there will be greater spending on domestic infrastructure as urban-isation takes place. This, when coupled with an increase in personal wealth, should lead to higher levels of domestic consumption and these positive trends should increasingly make emerging markets the guardians of their own destiny. This should benefit commodities and property, with both supported by high inflation.

Such powerful drivers, coupled with factors such as more robust fiscal positions than the West, also underpin our longerterm, positive views on emerging market equities.

We are positive towards the outlook for oil and hard commodities in general and as such we favour Russian equities, where we see supportive fundamentals while equity valuations are also low versus their historic average although political risk remains a source of market volatility.

Equities are also attractively valued in Latin America on a price to earnings multiple of around nine times 2012 earnings. At the macro level, many countries in the region are in better shape than developed markets, with higher levels of consumer confidence and solid fiscal accounts.

In the event of a prolonged downturn, these economies have tools at their disposal to deal with it, with ample room to reduce interest rates to stimulate the economy, for example.

Looking at the export-heavy Asian countries, the global slowdown has clearly had an impact but we view the backdrop favourably, with economies offering stronger growth than the West.

Inflation is showing signs of moderating and looser fiscal policies could help increase consumer demand. Within Asia, we favour Chinese equities, where we believe valuations are currently attractive.

The market is trading on about eight times 2012 earnings. Rapid rises in residential real estate prices could reverse and become destabilising to parts of the economy but we believe that a soft landing is the most likely outcome.

Alec Letchfield is chief investment officer, wealth, at HSBC Global Asset Management (UK)We continue to see significant risks during this ongoing deleveraging phase, not least because authorities are being compelled to keep monetary policy extremely loose in order to offset the dramatic fiscal austerity that is being applied

This dangerous cocktail of extreme monetary and fiscal policy stances can have significant side-effects which are hard to forecast.

Indeed, this environment of high risk but loose monetary policy might allow riskier markets, in the absence of any key event, to move higher.

Just like commuters who have heard a bad weather forecast, markets will constantly walk around with an extra layer of inclemency protection. We believe this protection and the cheap funding rates could lead to modest risk-taking and decent returns, especially if the Armageddon forecasters get it wrong.

Another consequence of these extreme policy initiatives and the increasing political risk is that markets could become less correlated, in our opinion.
Those more vulnerable to liquidity squeezes and government policy changes, such as Hungary, could be picked on while yield-chasers could bid up markets, such as Poland, that do not have the same problems.

This better, albeit not great, investment environment will be severely challenged later should economic growth fail to live up to expectations but, for now, while the sun may not be shining, at least we are not in the midst of a tornado. Meanwhile, the potential for the eurozone to fall apart remains, as fiscal austerity is applied to already weak economies, bringing about recessions and deteriorating government finances as well as increasing banking sector concerns.

We believe the European Central Bank needs to offset this fiscal drag with aggressively loose monetary policy and it can only do this (legally) via the banking system. The three-year repo structures help but their support for the peripheral government bond market may have been over-estimated in our view.

Peripheral eurozone government bond supply during the first half of this year is likely to provide a constant hurdle, requiring sustained demand from banks.

We would be more sanguine about the prospects for peripheral European government bonds if the prospects for economic growth and politics were better but the spectre of Greece’s private sector involvement issues and Standard & Poor’s downgrade continues to overshadow the markets and create uncertainty.

Paul Brain is manager of the Newton global dynamic bond fund

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