Global growth should pick up slightly in 2013 on improvements in both the advanced and developing economies, says State Street Global Advisors’ global CIO Rick Lacaille.
However, risks remain skewed to the downside, he said, reflecting potential fallout from the Chinese slowdown, the European debt crisis and the US fiscal cliff.
He adds: “Investors have become all too familiar with the headwinds to economic growth and corporate profits and therefore remain concerned with the potential for losses on risky assets. Recent experience indicates the firm intention of central bankers to keep financial conditions stable for an indefinite period. The hedge that investors need most may not be robust protection against massive downside, but rather sustained performance amid prolonged stagnation.
He says a lack of compelling alternatives should keep investors attracted to equities, even though growth prospects are “tepid” and the outlook for company profits “uncertain”. Yield-oriented portfolios should retain considerable appeal.
On the US, Lacaille notes the lack of any significant change resulting from the US elections. But, he says, the US debt ceiling must be raised by mid February 2013. “We believe there will be a short-term extension of most of the sequestration measures, and then major tax legislation in 2013. Taxes as a percentage of GDP will rise and the Bush tax cuts will likely expire.
“We can expect policy-related volatility in the US market until the resolution of this issue. However, a resolution of the fiscal cliff in the Lame Duck session of Congress between now and January could lead to a sharp rally.”
To hedge the risk of unanticipated inflation, commodities and real assets should form part of every investor’s portfolio for whom inflation concerns eclipse the need for nominal returns, says Lacaille. “We advocate at least a 5% holding. If the global economy and particularly China reaccelerates in 2013, we would expect commodities to rally.
On inflation, he says: “Given the large output gaps in the US and Europe, we do not believe that inflation is likely to accelerate sharply in 2013. However, we advocate that investors hold roughly 15% of their portfolios in a basket of unanticipated hedges: commodities, REITS, inflation-linked bonds and natural resources stocks.
Lacaille says the Japanese economy continues to experience deflation and return on equity among Japanese companies is well below that of other regions. Deteriorating relations with China could also negatively impact Japanese earnings in 2013. While we remain cautious on Japan we believe that investors should hold a strategic allocation.
In today’s environment, the key challenge for investment managers is achieving positive absolute return. Lacaille says: “The question facing investors and their advisors should not be whether to invest actively or passively but, rather, which instruments will achieve their portfolio‘s total return target.
“Although it is often said that areas of financial markets where information is scarce and securities valuation is less well researched offer superior return potential, the evidence across all managers is less convincing and it remains a challenge to forecast manager performance.
“However, behavioural anomalies such as loss aversion and the value effect fluctuate in their intensity, and areas of the world about which investors take extreme views – such as the periphery of Europe and China – may offer potential for discplined bargain hunters.”