Please find attached comments from John Chatfeild-Roberts, Chief Investment Officer, on the current situation in markets and the outlook for 2012. The views expressed are his own.

The crisis in Europe has legs yet.  The ‘Merkozy’ plan to introduce stricter fiscal compliance may have soothed financial markets’ nerves in the short term, but there is significant uncertainty as to whether weaker countries, which are already struggling under enormous debt burdens, will be able to cope with the new disciplines.  Moreover, if no-one kept to the original set of Stability Pact rules (including Germany!), why should a new set of rules fare any better?

The failure by European politicians to treat this is an insolvency crisis rather than a liquidity crisis will ensure that Europe has a substantial negative impact on world growth.  The ECB has signalled that Europe will suffer a recession in the next year, if it is not already in one.  If that is the case, the UK will not be immune from the knock on effects.

As investors we have found ourselves this year on the “weighing scales” like never before; on one side, there has been a pessimistic macroeconomic outlook and, on the other, some attractive asset valuations.  Markets have swung like a pendulum on a daily basis as investors try to assess the impact of these opposing pressures.  Predicting the final outcome is very difficult but what is clear to us is that further financial blood-letting will be required before the global economy can heal. 

The sovereign debt crisis has created a dilemma for investors – what is the definition of investment risk? 

In a world where sovereign debt and the banking system are under such strain, cash and government bonds may not offer the kind of comfort investors might traditionally expect.  Even supposed ‘safe havens’ are not what they seem – there is no such thing as a risk-free investment and one should not confuse volatility with risk.

If you analysed sovereign debt in the same way as you would equities, you might well conclude that a yield of 2.1% on the 10 year gilt, for example, is paltry recompense for an over-owned, overly indebted investment that is priced at a fifty year high, offers no long term growth prospects, no dividend growth and no protection against inflation.  The US, although burdened by high debts, looks like it is starting to recover and is not quite in the same category as gilts as the dollar is still the world’s reserve currency. Still, a yield of 2% on the 10 year Treasury suggests to me that this is not a cheap investment.

The equities of healthy multi-national companies with strong balance sheets that can maintain good dividends look far more attractive.  Share prices may be more volatile in the short term but I would, for example, feel more confident investing in a portfolio of high quality income stocks such as Johnson & Johnson or Glaxo, which have attractive valuations and offer healthy dividend yields of around 3.5% and 5.2% respectively, than I would investing in the bonds of most supposedly triple A rated countries or, for that matter, in deposit accounts of most European banks.  Such dividends are decent compensation for any short term price ups and downs one might have to endure.

While Europe remains in crisis there are brighter spots in some emerging markets.  China’s property market is looking distinctly sick, and in 2011, emerging markets have not been a profitable place to invest.  However, there is a good chance that when the rapidly-growing middle classes in these countries do eventually start to spend on a western scale, we might finally witness a genuine de-coupling of the two speed global economy that we have spoken about in the past.  Investors with any eye to the long-term will profit from this.

We are starting to become more confident that the US economy is recovering.  I think that we are seeing the bottoming out of its housing market, which, let’s face it, has fallen over 30% unlike that in the UK (though regulatory stress tests have been announced to assess the impact of further price falls on banks in the short term).  Given the continued population growth in the US, there will not be a housing surplus for ever and more houses will need to be built.  Buying a house in the US now may be a good investment decision long term.

Europe will eventually recover; and we know that markets will move to discount this well in advance of all of their problems actually being resolved. 

At this stage we are still minded to remain on the defensive.  The point will come when the scales start to tilt back to favour increasing risk levels but we are not there yet.  Investors need what Tolstoy called “the two most powerful warriors”: patience, and the time to get the most out of their investments.