Review of financial markets performance - 2012

Investment Notes

As 2012 comes to an end, a review of the performance of financial markets indicates that it has been (at the time of writing) a relatively good year for returns. The major equity indices have managed very acceptable gains - the UK 6.5%, the US 12.5%, Europe 13.5%, Japan 10%, Hong Kong 22%. Asian equity markets, except for China, once again delivered the best returns for global investors.  Government bond yields have moved lower adding some capital gains to the ever-lower income yields, while corporate and peripheral Eurozone government bonds made more substantial gains as credit risk perceptions declined and equity markets rose.

Somewhat surprisingly sterling has been the strongest of the world’s major currencies, gaining 2% against the Euro, 4% against the dollar and 13% against the yen. With the very substantial proportion of UK stock market earnings generated overseas, this currency strength probably accounts for the slightly weaker performance of the UK market in 2012. The best performing currency was however gold which is 7.5% higher in dollars, and 3.5% higher in sterling.

And yet, throughout the year, economic growth in Europe, Japan and China has consistently been disappointing with Europe and Japan slipping back into double-dip recessions. Forecasts of company profits globally are about 6% lower than the levels expected at the start of the year, and European profits much worse than this. Once again this year demonstrated that correctly forecasting economic growth or company earnings can be of little value in determining movements in asset prices.

The most significant factor in this year’s good returns is that last December there was a great deal of fear in markets that the problems in the periphery would be too much for Europe’s politicians to be able to deal with. Stock markets thus began this year a little depressed, but rallied quickly in the first quarter after the announcement of two Long Term Repurchase Operations (“LTRO”) by Mario Draghi.  These provided about E1bn of liquidity for 3 years at 1%, which was mostly taken up by banks in the periphery, who were able to use this liquidity to buy their own governments’ bonds at much higher yields. This generated profits for them and much-needed demand for their governments’ bonds.

After this strong first quarter, markets then gave back the gains in the second quarter as the impact of the extra LTRO liquidity faded and the global economic data started to fall short of expectations.  The Greek election (just) managed to deliver a coalition majority in favour of the bailout and austerity programme agreed with the EU and the IMF.  However the economic and fiscal situation in Spain was deteriorating rapidly over the summer, once again calling into question the survival of the euro.

In late July, Mr Draghi announced his willingness to buy up the bonds of the weaker countries in potentially unlimited amounts, and “to do whatever it takes” to ensure the survival of the euro.  This was openly opposed by the Bundesbank but once markets understood that Mrs Merkel was supporting Draghi, equity markets and the peripheral government bond markets rallied strongly to the end of the year. Then, in September, Ben Bernanke announced a policy of monthly Quantitative Easing to be continued, initially indefinitely, or following December’s Federal Reserve meeting, until there has been sufficient recovery for the rate of unemployment to fall below 6.5%.

Since the late summer, it has been the policy actions of the ECB and the Federal Reserve that drove the markets higher, even as the economic news across Europe, the US, Japan and China continued to disappoint. 

Thus the fear in financial markets, and consequent low prices, at the beginning of 2012, has given rise to the healthy returns from many investments over the year.  The transition from that fear to the more current sense of complacency, together with the poorer performance of the global economy and corporate profits, means that markets begin 2013 at more expensive levels, leaving less scope for gains next year.