2013 – A look ahead

Expect more of the same in 2013 – continued uncertainty, modest growth and equities over fixed income

Now that the holiday decorations have been put away for another year and my first New Year’s resolution has been broken, it’s time to look ahead at the investment environment for 2013. Not surprisingly, we expect that 2013 will look an awful lot like 2012 with headline risk being the main drivers of market volatility and return.

While much of the fiscal cliff has been averted in the U.S., there are still questions surrounding the robustness of their economic recovery. In Europe, the debt crisis is still a long way from being fixed, and the region remains mired in a crippling recession. Signs of life are showing in the emerging markets, but much of it will be dependent on China and how quickly they can turn things around.

Let’s take a look at some of the major asset classes and break down their prospects for 2013.

Fixed Income

In the U.S., Federal Reserve Chairman Ben Bernanke has committed to buying up to $85 billion in bonds each month, and has stated that interest rates will be on hold until unemployment falls below 6.5%. Looking at current projections, that isn’t likely to happen until at least 2015.

In Canada, we have managed to weather the economic storm thus far, but some cracks in the armor are beginning to show, most notably in the housing market. While a full scale collapse like we saw in the U.S. isn’t expected, a modest slowdown is, which will have a trickledown effect on the entire economy. With this risk looming large, and the threat of inflation in the near term a non factor, interest rates in Canada aren’t expected to move higher this year or possibly next.

With interest rates on hold and very little room to move lower, the best estimate of the expected return of fixed income is its yield to maturity less fees. On December 31, the Bank of Canada reported that Government of Canada 10 year bond was yielding 1.80% while the two year was yielding 1.14%. Corporate bonds offer a better yield, with the DEX All Corporate Bond Index yielding approximately 2.85%. Back out fees and the outlook for fixed income for 2013 is flat to slightly positive.

That is not to say that you should sell your fixed income holdings. While they are not expected to contribute meaningfully to your portfolio’s total return this year, they will still be a great shock absorber and help lessen the overall impact of the volatility of your equity holdings.

Canadian Equities

As mentioned above, the housing market is a big risk to the Canadian economy. A marked slowdown in the housing market will result in lower levels of consumer spending and slower economic growth. We are also very much affected by the price of commodities and the growth levels in both the U.S. and Chinese economies. If one or more of these slows dramatically, our markets and economy will feel it.

There is also some worry that Canadians may be in the early stages of a debt reduction process. While it may be great for the individuals, its short-term affect the economy is not as favorable. For 2013, BMO Economics is forecasting that Canadian GDP growth will come in at 1.8%, down from the forecasted 2.0% for 2012.

There remains significant headline risk in the global economy that will have the potential to result in periods of very high levels of volatility.

Despite the above, it is not all doom and gloom. Corporate profitability has remained strong and is expected to have another good year in 2013. While official forecasts may be a touch optimistic, it is not unreasonable to expect that corporate profitability growth will be in the 5% to 7% range. If we use corporate profitability as an estimate of share price growth, then it is not unreasonable to expect Canadian equities to return mid to high single digits in 2013. Should we see a marked turnaround in the U.S., China or commodity prices, there is potential for even greater returns.

With modest growth expected, we continue to favour actively managed funds that focus on well-managed, high quality, dividend-paying companies. In a low growth environment the dividends will provide some level of return and help protect against volatility. Given the potential for a slower economy, we are also favouring large caps over small caps for the year.

U.S. Equities

With a deal in place to avert the fiscal cliff, the focus for the U.S. becomes maintaining the fragile economic recovery. To help with this, the Federal Reserve has stated that it will continue to inject massive amounts of liquidity into the economy. In doing so, it hopes that economic growth will rebound, creating jobs and bringing down the stubbornly high unemployment rate, which is currently sitting at 7.8%. While the number of jobless continues to be a problem, recent numbers show improvement is being made.

Another positive sign is that after years in the doldrums, the housing market is on the rebound. Given the tremendous multiplier effect that housing has on the overall economy, this can only be a good thing. BMO Economics is expecting that GDP growth for the year will be 2.4%.

While the economy is on the rebound, equity markets may be in for a bumpy ride. While the New Year’s Day agreement dealt with the fiscal cliff, it did not address the debt level. On January 2^nd, U.S. Treasury Secretary Timothy Geithner announced that the country had hit its debt ceiling, which gives congress about two months to reach a deal, or face the consequences including defaulting on its interest payments and not meeting other financial obligations. There is little doubt that this will be a hard fought battle that will create significant uncertainty and volatility for the equity markets.

Despite this potential volatility, we expect that markets will post modest gains this year. With an improving economy, low inflation and decent corporate earnings growth, it is not unreasonable to expect returns in the mid to high single digits.

European Equities

Europe is in a very challenging position at the moment. On one hand, many Eurozone countries need to get their crippling debt under control and need to make dramatic spending cuts to do that. Yet on the other hand, the necessary austerity measures are stifling any meaningful growth potential. The result is a very dysfunctional economy.

The unfortunate thing is that this is not likely to change anytime soon as the stronger northern countries, namely Germany, continue to push for even deeper cuts. This approach does very little to solve the actual problem, and with reduced government spending, there is very little growth to allow the indebted countries to grow their way out of the crisis.

Because of this, we expect more of the same in Europe in the coming year – slow or negative economic growth and periods of extreme volatility. We also expect markets to move based on headlines as much as the market fundamentals. We don’t see much in the way of market growth in the region until the crisis is solved. However, for those active, higher risk investors, there may be some interesting shorter term trading opportunities in the region, where you could invest when market valuations become attractive and sell when the markets rally to close the valuation gap. This is definitely not a strategy for everyone, but for those with good timing, profits can be made.

Emerging Markets

After a few years of disappointment, it appears that the emerging markets may be poised for a turnaround. China has been struggling in the past year or so, but early signs seem to indicate that the country is on the rebound. While this may be the case, we don’t expect that economic growth will rebound to the levels we saw before the slowdown. Many economists are predicting more modest growth in the 7% to 9% range. As China improves, we should also start to see some support for commodity prices.

From a valuation perspective, many emerging market equities appear to be attractively valued compared to their developed market brethren. The biggest risk to the region will be the overall strength of the global economy. Since many emerging countries are exporters, if more developed markets continue to slow, export demand will slow and negatively impact emerging countries.

We do remain cautiously optimistic on the emerging markets, but we also expect that they can exhibit periods of high volatility. Because of this, we would suggest that those with more conservative investment approaches avoid the region in the short term.

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