Monthly Investment Strategy Update February 2012

• Risk assets begin the year on a positive note

  Risk assets have had a positive start to the year on the back of continued stronger data from the US, signs of a soft landing for the Chinese economy and hopes for policy easing as a result. The liquidity injection from the European Central Bank (ECB) in December through its long-term refinancing operation for European banks and, more recently, an indication from the US Federal Reserve (Fed) that it will keep interest rates at record lows until 2014 have also helped support risk appetite.

  Risk assets can continue rallying as long as US and emerging-market data continue to show a firmer tone and the euro-zone crisis does not deteriorate further. However, the potential for something to go wrong in Europe over the course of 2012 remains high. The S&P downgrades for nine euro-zone sovereigns in January and the ongoing fraught negotiations over private-sector involvement in Greek debt restructuring are just two examples of potential catalysts for increased volatility.

• Improvement in US data

  US private-sector non-farm payrolls grew 212,000 in December. In addition, the small business optimism index rose to its highest level since February 2011 – small businesses account for 50% of the US economy. There are also tentative signs of improvement in the US housing market. We expect US growth in 2012 to be 1-2%, with data at the moment consistent with growth at the higher end of this range. Though far short of spectacular growth, investors have been encouraged by the fact that the US economy has pulled away from imminent risk of recession.

• Hopes for policy easing in China

  Chinese data continues to provide evidence that policymakers are successfully engineering a soft landing for the economy and, in due course, will gradually ease monetary policy to support growth. Chinese inflation at 4.1% is now at the low end of policy-makers’ target range giving them more room for manoeuvre. Chinese Q4 GDP growth came in at an annual 8.9% pace, down from 9.1% in Q3, but above expectations.

  We see at least three factors that should give support to Asian emerging-market (EM) equities this year: they tend to be more sensitive to policy changes than developed markets and Asian policy-makers (specifically in China) are now making the important move from a tightening to an easing stance; various valuation metrics, such as prices relative to earnings (PE) and book value (PB, book value being assets minus liabilities), are at attractive levels; and finally, we expect gradual appreciation in their currencies.

• Europe still has the potential to create volatility

  Standard & Poor’s recent credit-rating downgrade of nine euro-zone countries and subsequent cut to the European bailout fund’s rating were widely anticipated and didn’t unsettle markets. However, France’s cut from AAA to AA+ could complicate efforts towards fiscal integration by strengthening the hand of fringe parties in forthcoming French presidential elections.

  Cyprus, Italy, Portugal and Spain all had two-notch downgrades. This took Italy’s rating to BBB+, just three notches away from sub-investment-grade, or junk, status on the Standard & Poor’s ratings scale. Indeed, Portugal’s two-notch downgrade pushed it into junk territory, causing yields on its 10-year bonds to jump and highlighting the risk facing other countries such as Italy.

• Valuations attractive, especially for Asian EM

  When using current PB levels as a starting point, equities in the Asia Pacific region (ex-Japan) have historically seen positive returns over the next 12 months roughly 90% of the time, though past performance is of course no guarantee of future returns. Investment-grade corporate bonds also look attractive, with yield spreads over government bonds being at historically high levels. Gold, after a pullback in late 2011, has resumed its upward trend in response to the accommodative liquidity positions of the ECB and Fed. This supports our long-held view that the ultimate policy response to many of the economic problems facing the developed world would be more money printing by major central banks and a debasement of fiat currencies versus hard assets and stores of value such as gold.

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