Earlier this month, I suggested that investors closely watch 12 macroeconomic and financial indicators in deciding whether the world economy is improving or worsening (12 Indicators for 2012, January 3, 2012). Some readers wrote to ask if I would discuss what those indicators would mean for investment strategies. That was the genesis of the present piece which is intended to be consistent with expectations on the economic and financial fronts.

1. Short the euro, especially after last week’s strengthening!

Optimism about a resolution to the Eurozone’s problems rose this month despite Standard & Poor’s decision to lower the French sovereign rating one notch from its erstwhile AAA. The European Central Bank’s introduction of €489 billion in up to three-year repurchase agreements last month appeared to have averted an imminent credit crunch for European banks, Spain and Italy had successful debt auctions, and officials were in intense negotiations to reach a debt deal for Greece. Even though banks’ purchases of shorter-dated sovereigns have lowered yields on those obligations, this has not happened to the same extent on 10-year paper. It is doubtful that Greece will make it without a crisis to March 20 when it has to make a €14.5 billion payment, or that yields will remain low for Italy which has to refinance over €300 billion this year, accessing the market virtually every week.

A euro forecast of $1.25 in mid-2012, weakening further to $1.20 by year-end.

2. Short European equities as well, they have further to fall
First estimates suggest that German GDP contracted by 0.25% quarter-on-quarter during the final quarter of 2011. With the contagion finally having hit the largest and strongest member of the Eurozone, the entire region appears to have entered a recession. This is not yet reflected in equity prices. Through January 20, the French CAC 40 index was up more than 5% since the beginning of the year, with the German DAX index up over 8%.

European equities should reverse the positive performance so far.

3. High-grade fixed income rally has further to run

Defying a downgrade by S&P last August and growing concerns about a bond bubble, 10-year U.S. Treasurys hovered around 2% late last week. The bonds had risen in yield over the week in response to positive news on U.S. jobless claims, and manufacturing showing signs of picking up. German bunds and U.K. gilts, other erstwhile safe havens, also lost value. A growing belief that the ECB version of quantitative easing was working, and that Greece negotiations were coming to a successful conclusion, also helped push up yields. Despite these recent developments, I believe that the combination of a European recession, and deterioration in the Europe debt situation, will push yields in the haven countries below where they were at the end of last week.

Allocate to a basket of U.S., German and U.K. Treasurys with a maturity of at least 10 years.

4. Profit from both improving, and deteriorating, credit fundamentals in Europe

If, as I believe, the European debt crisis is no closer to being resolved despite the drop in French, Italian and Spanish 10-year debt yields in recent days, not only are these yields likely to rise but also, the yield on German bunds should drop. For even higher expected returns than merely purchasing German paper, investors should play the spread between the French and German debt. If the recession in France should worsen, lowering tax revenues, or if Socialist candidate François Hollande should beat President Nicolas Sarkozy in elections to be held in April and May, French yields will likely rise even as Germany’s position as a haven is strengthened.

For higher-octane strategy, play the France – Germany spread.

5. China to have soft landing, buy equities to hold over medium-term

Compared with the S&P 500 index which was essentially unchanged last year, the Shanghai Composite index fell by almost 22% making China one of the worst performing equity markets. The 5% upturn in the Shanghai index through last week enabled it to roughly match the S&P 500 performance so far in 2012. Recent economic numbers from China suggest that the economy slowed following the government’s efforts to reduce speculation in property markets and to lower inflation. With inflation showing signs of moderating, the central bank cut the required reserve ratio for lenders for the first time in three years. More easing is likely which will be welcomed by Chinese equity investors.

Chinese equities should outperform U.S. equities in 2012.

6. Emerging Markets: New Safe Haven?

As recession concerns mount and have their impact on developed country equities, emerging market equities may provide better value than their developed market counterparts. While a slowing global economy will put a damper on emerging market equities because of a less robust expansion in exports, they still promise more rapid long-term growth, and a faster rerating of multiples.

Increase the percentage of emerging market equities in the portfolio.

7. Defensive sectors should dominate investments in the United States

Consumer Staples, Health Care and Utilities were among the top performing sectors in U.S. equities during 2011. They are likely to provide the best returns during the first half of 2012. Assuming that the impact of a European and U.S. recession gets better incorporated in U.S. equity prices, more “aggressive” sectors, e.g., Consumer Discretionary, may become more attractive.

Stay in the defensive sectors in U.S. equities in 1H2012, prepare to switch mid-year.

8. Small- and mid-cap U.S. stocks: Safe harbor from Europe’s problems

Smaller U.S. companies are less dependent on foreign sales than S&P 500 or S&P 100 companies. At a time when the European recession will be worse than the resultant downturn in the United States, U.S. small- and mid-cap equities will likely outperform their large cap counterparts.

Domestically oriented U.S. companies are likely to provide safe harbor to investors.

9. Hold cash for “distress” investments

Investors should watch for the European situation to turn toward the middle of the year. If proposed haircuts extend beyond Greece to Portugal, and even to Italy, that may be when European leaders will undertake measures to permanently resolve the debt crisis. If this includes structural changes, e.g., to boost labor productivity in the peripheral countries, that could mark the low point for European assets.

Switch to investments in European “distressed” debt and equity at mid-year.

10. Emerging market debt: It is still dollar-denominated paper!

While emerging market debt denominated in dollars provided positive returns during 2011, local currency obligations were adversely impacted by the depreciation of various currencies and the flight to dollars. This is likely to be repeated in the first half of 2012 until the economic outlook for the developed economies becomes clearer. It would take a significant shift toward risk preference, and a weaker dollar, to move investor preference toward local currency debt.

Dollar-denominated emerging market debt is likely to perform well even with Europe recession.

11. Make room for alternative investments

I have long believed that lock-in medium term investments directed toward promising areas, and in the hands of good managers, should be a significant part of an investment portfolio despite the illiquidity of the alternative strategy. Even though net present values may not be calculable on a daily or even monthly basis, the illiquid investments may also preclude the investor heartburn from day-to-day fluctuations in financial markets. Strategies that seek to provide loans for smaller U.S. companies that are unable to get bank financing, and investment in global infrastructure including emerging market real estate, are among the preferred areas.

Significant portion of allocation to go to illiquid investments.

12. Keep small percent of portfolio in Frontier Markets

Don’t forget that the BRIC nations (Brazil, Russia, India and China) were often thought of as the frontier nations for investment during the late-1980s and during the 1990s. Although the BRIC markets have been more volatile than their developed counterparts, they have outperformed their developed counterparts over longer time periods. Today’s “Frontier” markets, many of them located in Africa, are likely to become more prominent in investor portfolios.

Include a small, say, 2% allocation to Frontier Markets for long-term returns.

(c) TCW Asset Management

www.tcw.com

         
 

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