Investment Commentary – January 2012

The first six months of last year saw markets coping with a range of unforeseen problems including political uprisings in the Middle East, and the Japanese earthquake. In the background, there was increasing belief that the long awaited recovery in the American economy was finally underway.

It was, however, politics that came to the fore, and dominated markets in the second six months. The uncertainty generated proved too much for investors who fled from risk assets, with major falls in Europe and Emerging Markets.

The trigger for this was a failed attempt to resolve the Greek debt crisis in July, followed by grandstanding over the American debt ceiling in August, which resulted in a downgrading of the sovereign debt rating. In a year characterised by the unexpected, this asset class had a very strong six months, and was one of the outstanding performers of the year, beaten only by UK Gilts.

Hidden amongst all the noise at the time, previously announced GDP figures were revised downwards, indicating that the recovery was not as strong as previously thought. A double dip recession, thought unlikely, suddenly became a near certainty.

The unresolved Greek deficit problem resulted in contagion across the weaker members of the euro zone, leading to the fall of many governments, and in the cases of both Greece and Italy, their replacement by unelected officials. Sovereign debt is widely held across the European banking system, and as the autumn progressed, liquidity deteriorated rapidly.

This was largely the result of the refusal by the German government to allow the central bank to engage in quantitative easing, a method adopted by both America and the UK. Summits followed one another like buses, and markets reacted in either hope or despair, creating great volatility.

Away from the political indecision, companies generally made good progress, although this was drowned out by the euro zone problems, and equities de‐rated again, finishing the year on approximately ten times earnings.

Encouragingly, the data coming out of America has shown an improving trend, and thus that equity market was able to disconnect from other markets, ending the year in marginally positive territory.

The other significant change, albeit on December 21^st, was a move by the European Central Bank to lend EUR 489 billion, an offer accepted by 523 banks. This is 3 year money, at a low rate of interest, and is designed to allow the banks to purchase Sovereign debt, and profit from the differential return.

Outlook

Clearly, after the events of 2011, volatility is going to remain to the fore. The most critical point is to watch for a credible solution to the problems within the euro zone. Realistically, this is not going to be solved until a more federal approach is adopted, and that seems a long way off. In the short term, it is likely that a further tranche of funds will be made available by the ECB on February 29^th, and this may prove enough to remove the log jam in the banking system, and kick start the economy.

Continuing growth in emerging markets, and a more positive backdrop in America could lift the gloom, but politics will continue to have a dominant effect.

By most historical standards, equities are undervalued, and they are certainly unloved, despite yielding substantially more than debt issued by countries deemed to be safe. At some point, investors will recognise this increasing anomaly.

David Oakes, Chief Investment Officer

18^th January, 2012