Economic trends & Market overview

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This year has started with very strong equity performance and over the first quarter the S&P was up 8.6%, the Nikkei 15.5% and the FTSE 9.5%.

As you may have noted in our previous publications, this move was part of our strategic scenario as we were expecting a rise in equity markets based on healthy company fundamentals, a brighter global macro picture and a greater willingness by investors to take risks.

After such positive moves in markets over several quarters, is it not time to take profits and to be more defensive? While we acknowledge that the road may be bumpy as there are still a lot of economic-political issues to be fixed – the recent episode in Italy and Cyprus are good reminders of that – our strategy continues to favour equity investments. We particularly like companies either linked to capital expenditure or companies taking advantage of the very low energy price in the US. More globally, we like to think that global high quality companies with proven business models will continue to perform well in the current environment.

While the Eurozone should face a negative gross domestic product (GDP) of -0.6% in 2013, we expect the US economy to grow at slightly more than 2% on the back of real estate price recovery. We also expect to see improvement in the labour market and a recovery in its global competitiveness. On the Asian front China should see a pick up of its growth to 7.8% for 2013 while Japan is expected to grow by 2%.

In this environment, still benefiting from the support of central banks' liquidity injections, we are more inclined to sell our bond exposure as ultimately a more sustainable recovery will trigger an increase in interest rates.

LOOK WESTWARD, THE LAND IS BRIGHT
written by John Birdwood, Head of Discretionary Absolute Return Portfolios

The financial crisis began to emerge six years ago. Since then, the leading equity markets have gone down and up more or less together. This has resulted in annual total returns of 3.3% and 4.5% for the USA and the UK respectively, from March 2007 in their own currencies.

Despite the similar pattern of returns, each country has had very different experiences and the contrast between the position that the USA now finds itself is in marked contrast to that of the UK. As Mr Osborne, the UK Chancellor reminded us, Britain, towards the end of March, is struggling to reduce its budget deficit and faces another year of low growth, at best. The American budget deficit is expected to be 5.8% this year, which is better than the British figure of 7.8% – though it is hardly good – but the key difference is that the American economy is now some 4% larger than it was when the crisis began, while the British economy is still somewhat smaller than it was.

Given that the financial crisis started in the United States it is worth examining why this is so. We believe that there are four principal reasons:

Firstly, the American commercial banks were never as heavily geared as their counterparts in Britain and they were encouraged to pursue a more vigorous policy of recognising loan losses. The Governor of the Bank of England, in his recent testimony to the Banking Standards Commission, recognised this when he said that RBS should be split up into a good bank and bad bank. Had this been done five years ago we too might be experiencing steady increases in bank lending.

Secondly, house building is making a strong recovery in the United States. Housing starts, which averaged 1,800,000 units a year between 2000 and 2006, fell to an annual average rate of 813,000 between 2007 and 2011 but have finally started to regain strength with the annual rate now running at more than 900,000 units. Looking ahead, substantial pent up demand, significantly lower house prices, a liberal planning process, and cheap available mortgage finance point to continued strong recovery. The contrast with Britain is stark.

Thirdly, the developments in the energy business in the United States continue at a rapid pace. The abundance of natural gas delivered by hydraulic fracturing is giving the United States substantial competitive advantages in electricity prices, transport costs and refining and chemical businesses. To illustrate the scale of the opportunity, Burlington Northern, the American railway company, announced in March that it was planning to test whether it could run its engines on natural gas rather than diesel. It has more than 6,900 engines and burns 1.3 billion gallons of diesel a year. Last year, diesel cost the company about $3.97 a gallon. The equivalent amount of energy in natural gas would cost it $0.48. Meanwhile, in Britain, the commercial development of our own shale gas resources remains somewhere in the future.

Fourthly, Britain's largest export market, the European Union, is barely growing while the United States is experiencing robust demand for its goods and services. Between March 2007 and January 2013 British exports grew by 28%. Over the same period, American exports grew by 72%.

Therefore, it seems surprising that the Price/Earnings ratio based on historic earnings for the UK market should be higher than it is for the American market. Adjustment should be made for loss-making companies in the FTSE. Nevertheless, we believe that the US market offers a better diversified set of equities, operating in a more successful economy which still appears to be steadily expanding: a situation which is likely to last several more years.

Changes in major indices (year on year, 31 March 2012 - 29 March 2013)

Indices are for guidance purposes only. Equity percentages are based on capital returns in local currency. Bond percentages are based on total returns in local currency.

Source: Bloomberg

Past performance should not be seen as an indication of future performance.

Recommended asset allocation*

*In relation to the SGPB Hambros benchmark allocation, as at 31 March 2013

Actual weighting and investment allocations are subject to change on an ongoing basis and may not be exactly as shown. Investors should understand the different asset classes which make up the strategy as they have different risk characteristics. 

EQUITIES

Changes in major indices (31 December 2012 – 29 March 2013)

Source: Bloomberg

Past performance should not be seen as an indication of future performance

United Kingdom

The trend of equity gains from last year extended into February and March as investor confidence increased, risk assets rose and government bonds sold off. The FTSE 100 Index hit a five-year high in spite of the uncertainty surrounding the Italian elections and a suggestion the Federal Reserve (the Fed) might end quantitative easing (QE) this year – the key support for equity markets in recent years. In contrast, the GBP/USD exchange rate hit its lowest level for over two years driven by the UK's credit downgrade from Moody's and speculation that the Bank of England might add more monetary support to the UK's weak economy. This has acted to further support the UK market as it makes companies more internationally competitive and their overseas earnings rise in sterling terms.

In company news, BT Group confirmed a fast roll out of its fibre optic broadband, along with further restructuring as the company aimed to deliver cost savings. Less positive news came from the mining sector. Rio Tinto posted its first ever annual loss as it made large write downs on previous acquisitions and BHP Billiton saw profits more than halve on the back of weak commodity prices.

Written by Tarly Bolla, Senior Investment Manager

Equity performance of major economies (ccy)

Past performance should not be seen as an indication of future performance.

United States

The US equity market had a strong start in the new year as investors were relieved that the lawmakers struck a last minute deal to hold off wide spread tax increase and postpone spending cuts, temporarily averting the 'fiscal cliff'.

Subsequently, stocks continued to gain despite an unexpected GDP contraction in the fourth quarter, as strong corporate earnings as well as further improvement in the housing market offset the weak GDP figure. The companies in the S&P 500 Index reported an average of 8% increase in profits for the fourth quarter of 2012 and 70% of the companies had earnings that are better than the analysts' estimates.

On the economic front, data on manufacturing activity, consumer sentiment and unemployment figures all remain largely positive in this quarter. There has also been a significant increase in high profile merge and acquisition deal announcements, from Dell's leveraged buyout, to Warren Buffet's $23 billion purchase of H.J. Heinz Co, which helped to boost investors' optimism on the equity market.

The automatic spending cuts by the Government, known as sequestration, took effect on 1 March. Although this would no doubt create a drag on the US economy, the impact is expected to be gradual. For now, investors have certainly decided to focus on the positives by continuing to allocate funds to equities, pushing the Dow Jones Industrial Average to a series of all-time highs in the first week of March.

Looking ahead, we expect earnings growth to be double digits for most US companies this year and continue to view valuation on the US market as attractive, albeit a short-term correction which is increasingly possible after the strong rally we had recently. 

Written by Jennifer Yu, Senior Portfolio Manager

US inflation (year on year % change)
(Mar 2003 - Mar 2013)

Past performance should not be seen as an indication of future performance.

Eurozone

European markets took something of a breather in the first quarter, and the Euro Stoxx 50 stalled at its January peak whilst investors digested the results of the Italian elections and fourth quarter earnings results.

The Italian election results were inconclusive and a compromise deal is still looking elusive. Investor uncertainty was reflected in a 13% fall in Italian stock markets. Fortunately, this magnitude of fall was not reflected across Europe generally and in truth had very little effect on global markets in aggregate.

In response, Italian 10-year yields have backed up somewhat. More promising are the Spanish yields which continue to come down and reach a new 28-month low this quarter. At this rate, the markets may do the job of the European Central Bank (ECB), without the Spanish government needing to request a bailout.

European fourth quarter earnings were at best in line with expectations and whilst not disastrous, still point to a very weak demand backdrop. However, we believe these numbers will mark a trough in earnings and we expect some improvement going forward. We continue to believe European equities offer attractive value whilst the weight of the ECB continues to offer support.

Written by Ian Leverington, Senior Investment Manager

GDP in the Eurozone (year on yea % change)
(Mar 2003 - Mar 2013)

Past performance should not be seen as an indication of future performance.

Japan

Despite the well-known structural and demographic issues facing Japan, expectations appear high that under the new LDP Government and the introduction of 'Abe-nomics' we can finally see an end to almost two decades of deflation in the country. This had the dual effect of a substantial weakening of the yen and a continued aggressive rally in the domestic equity markets. Prime Minister Abe's nomination of Haruhiko Kuroda to be the new Head of the Bank of Japan has inspired further confidence with the latter, stating that under his leadership the Bank of Japan would do whatever it takes to end deflation and that open-ended asset purchases could begin even sooner than 2014.

As signs of economic recovery have broadened and earnings forecasts have been increased, the first quarter rally in equities has been driven largely by the cyclically sensitive and export orientated sectors such as financials, real estate and consumer stocks. The defensive groups such as the utilities have been the relative laggards during the period.

Written by Paul Stappard, Senior Portfolio Manager

Emerging markets

Whilst Asia has been our favoured Emerging Market region for some time, the outlook for Latin America has also improved recently. In Brazil industrial production data shows signs of picking up, whilst in Mexico well controlled inflation has allowed a rate cut. As a result, the region's two powerhouses look increasingly on track for improving economic performance.

In the Central and Eastern Europe region Russia remains attractive, with very cheap valuation levels. There is potential for lower inflation targeting which we hope would lead to a lower cost of capital which should ultimately result in higher profit margins and an equity re-rating.

In Asia, the biggest catalyst for broad-based improvement in equity performance is the growth turnaround in China, where recent trade figures have improved significantly as exports to the US pick up. We maintain a positive view on Chinese equities, which remain on a discount of 25% to their 10-year average.

We also favour an overweight position in Taiwan, which although more expensive than some other Asian markets, does provide significant exposure to the technology sector, which represents 55% of the country's market cap. Technology is one of our favoured sectors in the region, along with financials and consumer discretionary.

Our view on Korea has been downgraded to neutral, on concerns of increased competition from Japan in the automobile and industrial sectors, following the depreciation of the yen. In Asia overall, we feel that inflation does not yet present a risk, allowing central banks to maintain any easy policy stance.

Written by Jonathan Torode, Senior Portfolio Manager

Equity performance of emerging markets (in USD)
(Mar 2012 - Mar 2013)

Past performance should not be seen as an indication of future performance.

Changes in inflation, interest rates and the rate of exchange may have an adverse effect on the value, price and income of investments. Your capital may be at risk and you may not get back the amount you invest.

BONDS

Changes in major indices (31 December 2012 - 29 March 2013)

Bloomber/EFFAS Government Bond (all maturities >1 year) Indices

Source: Bloomberg

Past performance should not be seen as an indication of future performance. Indices are for guidance purposes only.

The first week of January saw the worst weekly 10-year gilt performance in four years. The 'fiscal cliff' was averted and yields shot up to over 2.1%. This was the complete opposite to inflation linked gilts which reacted to news that no changes would be made to the formula of the Retail Price Index, which is referenced by index linked gilts. They posted their strongest day rally since 1987. By the end of February, the 10-year gilt had rallied and yielded under 2%. The Monetary Policy Committee minutes revealed that Mervyn King voted for further QE, surprising the market. The downgrade by Moody's was seen as symbolic and had little effect. The political deadlock in Italy soon overshadowed domestic worries, cementing the good performance into month end.

The recent strong rally in corporate credit has stalled. The uncertainties – politics, economic growth, the Eurozone crisis and asset rotation – are weighing on performance. Whilst spreads are still reasonable, total yields are very low making credit seem very expensive and leading to mounting concerns of a bubble. Whilst the path out of the crisis is unclear, the near-term capital conservation characteristics of credit make it a reasonably attractive alternative. We prefer subordinated financials, US High Yield and Emerging Market debt.

10-year government bond yields (Mar 2003 - Mar 2013)

Past performance should not be seen as an indication of future performance.

Changes in inflation, interest rates and the rate of exchange may have an adverse effect on the value, price and income of investments. Your capital may be at risk and you may not get back the amount you invest.

Last year, investors had heightened concerns about peripheral European borrowing costs. Since the ECB announced that it would step in if yields became unmanageable, borrowing costs have fallen. Even the inconclusive elections in Italy did not ruffle investors. Peripheral yields remain at relatively comfortable levels but they are still much higher than UK and German levels. US treasuries have been very sensitive to future QE policy. Current policy has pushed yields to low levels, but ironically if markets believe that QE will stop, it pushes investors back into treasuries, suppressing the yield again.

Written by Neil Bruce, Investment Adviser 

CURRENCIES
The pound has been one of the weakest G10 currencies year to date, and is likely to continue falling, with the apparent blessing of the UK's Monetary Policy Committee and the Chancellor. In the 'Currency Wars' the UK is firmly on the side of the 'quiet debasers' who do not intervene or talk their currency down loudly, but converse positively about what a weaker currency does to re-balance the economy and tackle the trade and current account deficits. Weakening the currency may not be a panacea as inflation is imported and hits consumers, while the UK offers increasingly price insensitive exports that are heavily dependent on Europe.

By contrast, the US dollar is now being bought on US growth, as opposed to only benefiting from capital inflows in times of uncertainty. Above expectations, payroll data has provided fresh momentum to the dollar uptrend. We expect dollar strength to be a major theme throughout 2013.

The euro is likely to remain underpinned by diverging policy trends (shrinking excess liquidity in the Eurozone and the Fed further expanding its balance sheet) and a greater appetite for risk in the short term. Yet the ECB recently talked down the euro, favouring a pull back. We stick to the view that the single currency may weaken later this year as the peripheral debt crisis has been mitigated, but not solved.

Written by Tony Abreu, Investment Adviser

USD relative to other currencies (Mar 2003 - Mar 2013)
EUR vs USD, GBP vs USD, JPY vs USD

Past perforamance should not be seen as an indication of future performance.

ALTERNATIVE INVESTMENTS 

Hedge funds have continued to show strong returns. At the end of last year they rallied close to 5% and have started the year positively measured by the HFRX, or average fund of fund, being up 3.05%.

We currently favour sectors which can add some more volatility in order to increase returns such as Long Short Equity, especially European equity and event driven managers. Positive market trends and low correlation between stocks have both helped these managers. We are now less positive on credit managers as we feel it is increasingly becoming crowded or expensive.

As a guide, strategies that have outperformed this year have been equity long short (up 4.75%) and event driven (4.97%). Underperforming strategies have included credit (up 2.51%) and Macro (up 0.15%). However, Commodity Trading Advisers, or systematic managers remain our least preferred hedge fund strategy (down 0.44% this year). Although it is worth noting that performances have improved recently given less dramatic political indecision or policy headlines.

While hedge funds have certainly underperformed equities this year, performance is recovering and we still believe they can serve a valuable place in a diversified portfolio.

Written by Alan Bodie, Investment Director

Permance of hedge funds relative to equities
(Mar 2003 - Mar 2013)

Past performance should not be seen as an indication of future performance.

Indices are for guidance purposes only.

This investment included herein may not be suitable for all investors and you should seek professional advice before investing. Most investments should be considered as a medium to long-term commitment, meaning investors should be prepared to hold them for at least five years. For products with a fixed term investors may get back significantly less than originally invested if there is an early withdrawal. Furthermore some asset classes may be less liquid than others and they may be difficult to sell before their maturity.

COMMODITIES
As previous demand for commodities has been largely correlated to demand from China and other emerging markets, the details from China's central budget and economic targets for 2013, released in March, were of interest. The framework of the policy detailed a moderate increase in infrastructure outlays, which would indicate only a modest pick up in future commodity demand, possibly adding to the already tough start to the year for some industrial commodities (aluminium and copper).

Investors have pushed the gold price higher over the last 10 years with the last 5 years' rally driven by fears that aggressive central bank QE would lead to very high inflation. So far, however, inflation has stayed low. With improving economic data coming out of the US, that could justify an end to QE, it would seem unlikely that investors would want to add to their gold positions, increasing the risk for gold to trend lower as the physical gold market is seriously oversupplied without continued large-scale investor buying. However, gold will still have a place in many investors' portfolios due to its defensive characteristics in a crisis.

Written by Will Jones, Portfolio Manager

Brent oil vs gold (Mar 2012 - Mar 2013)

Past performance should not be seen as an indication of future performance

COMPOSITE BENCHMARKS

2013 has started well for investors as a rotation into equities has produced strong returns for most indices. The Japanese markets have led the way as prospects of more policy stimulus have provided support, but the US and UK markets have also done well. Sterling weakness against the US dollar and the euro have also enhanced returns from these markets for UK investors.

Although bond markets have not been able to repeat the strong performance of 2012, returns have generally been positive as continued signs for economic weakness in many countries have reassured investors that central bank rates will remain low. Hedge funds have also enjoyed a solid start to 2013. Our composite benchmarks reflect the above patterns and show positive returns particularly for higher risk GBP strategies.

Written by Andrew Dalton, Head of Investment Services

Source: Datastream and Bloomberg
Hedge fund returns are estimated based upon HFRX data as of 28 March 2013

Past performance should not be seen as an indication of future performance.

Indices are for guidance purposes only.

Investments may be subject to market fluctuations and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk and you may not get back the amount you invest. All information is based on current tax legislation, which can change. SGPB Hambros Group does not provide tax advice. The level of taxation depends on individual circumstances and such levels and bases of taxation can change. You should seek professional advice in order to understand any applicable tax consequences.