INVESTMENT OUTLOOK
Assessment for the coming months
December 2011

The past months in retrospect and a glance ahead

The investment environment has worsened dramatically and very swiftly during the past few months. The debt crisis as the overpowering investment theme of the past months has overshadowed and infected all other aspects of a world economy in good shape until then. Very likely a large part of European economies have already slipped into a recession by now, and it won’t be long until other, more solid countries with sounder economies up to now will be contaminated, too. All told, the following will be the parameters of world economy in 2012: Slow growth rates or even recession, short term interest rates near zero, moderate inflation, disorderly default actions in Europe, and a frenzy of political and regulatory actions, fuelled by populism as a backlash against capitalism.
   

Commodities

For the next months we expect relatively stable commodity prices, with larger price swings only in precious metals, especially in gold. In a market environment where everything else looks bad, investors increasingly turn towards gold. That might take the gold price to new highs. It has to be born in mind however that gold has only so much value as investors convey to it. The gold price is mainly influenced by investors’ psychosis, and the question, whether this price is justified or not, is therefore completely irrelevant, which makes the gold price more vulnerable, the higher it gets.
       

The Economy

It is telling that we do not talk about the economy here, but about the debt crisis and the crisis of the euro system. The most imminent and threatening issue here is that hundreds of billions worth of debt of European banks and sovereigns will have to be refinanced in 2012, of which over 400 billions for struggling Italy alone; yet it is completely unclear how this will be done. As a consequence many market observers forecast nothing less than a collapse of the euro system. But that is not so easily done. First of all rewinding the euro system would result in tremendous costs for all involved parties. But there is much more at stake than just financials: At the very worst the whole of the European Union could collapse.

Moreover, solving Europe’s problems will not just be how to reschedule public debt; the main problem lies much deeper and is of a structural nature. Since inception of the euro end of the nineties costs of goods produced in Greece have risen by as much as 67%, Spain 56%, Portugal 47%, Italy 41%, while in Germany that figure is barely 9%. This means that southern European economies have priced themselves out of competitiveness, the main driver for this being labour costs: While Germany’s jobholders had to get by on a moderate salary increase, southern Europe spent to the full on wage increases and pension benefit plans. Thus in order to return to competitiveness, there will have to be deep cuts in production costs in southern Europe. To do so, we think that Europe has to choose between two options: Either to risk the brake-up of the euro system, or then to reinforce Europe’s political unification. Our guess is that Europe’s leaders will hold on to the euro system tooth and nail, undoubtedly under the leadership and terms of Germany, which has become the main creditor and paymaster of Europe. They will head for increased political and fiscal integration and towards reinforced control mechanisms. This, as well as the austerity measures which especially southern European nations are facing, will lead to increased riots, strikes and other turmoil. As recent examples have shown, populations are increasingly willing to remonstrate, be it against austerity measures or excrescencies of capitalism. Anyway we will see a tumultuous year 2012 filled with frenzied political activity, and the euro crisis as well as the public debt crisis will continue to dominate all agendas and all other investment themes for quite some time to come.       

Nevertheless a note on some economic parameters: Most probably many European economies have already slipped into recession territory, and the next sets of economic figures will indicate just how deeply. Of the mature markets only the USA will be able to cling to some measure of growth in 2012. Corporations will enter into a prolonged earnings downgrade cycle with slower growth rates. Their sales, albeit on a relatively high level, will be stagnating or declining. Earnings will diminish, but we forecast that many key players in key industries will be able to keep their profitability on a relatively high level.

Mainly in order to counteract the financial crisis, central banks have ever increased money supply over the past years and have provided the economy with cheap money in an unprecedented manner. The question arises why this abundance of money supply has not fuelled inflation so far. The main reason for this is that most of this money has not been used for consumption. Either it has been used to reduce debt, or then it sits idly on corporate balance sheets and bank deposits. As this is likely to remain so, inflation should not be a major threat in 2012. 

Economic forecasts for the next six months:

Currencies

For years now have we been highlighting the Swiss franc as the strongest currency worldwide and have we been hedging currency risks against the Swiss franc on a large scale. We reversed these positions some months ago, because now we expect a softer Swiss franc. Why? As has been said above, also solid countries with sound economies, like Switzerland, will be infected by the debt crisis raging in other countries. For Switzerland this means that Europe’s problems are actually Switzerland’s problems. While it is true that Switzerland has a proven track record of being able to live with a hard currency, the price explosion of the Swiss franc against all other currencies in 2011 has just been too much. In order to remain competitive on world markets, Swiss exporters had to cut their prices, thus substantially eroding their margins. While Swiss exporters are increasingly unable to compete on world markets at the current exchange rates, tourists, too, increasingly shun Switzerland as their destination: bookings for the coming winter season are down an alarming 5%. Clearly a weaker Swiss franc is in the utmost and vital interest of Switzerland. So by laying an intervention floor at 1.20 against the euro the Swiss National Bank recently has started serious action to weaken the Swiss franc and it will tenaciously continue to do so in 2012, no matter the costs. So the Swiss franc will tend to weakness in 2012.     

The role of the strongest currency in 2012 might well fall to the US dollar. While the fundamentals on the long term unwaveringly point towards a weaker dollar, they are more favourable on the short term. Firstly, the US economy will be stronger than that of most other mature markets. Secondly, the European Central Bank will have to lower rates, while the US Federal Reserve Bank will not have to do so. Thirdly: The USA will come out of the debt crisis much quicker, even be it at the cost of increased tax rates, because their leadership can act quicker and more efficiently, while Europe’s leadership is constantly hampered by the ongoing and fastidious process of having to hoist everyone into the boat.        
 
Currency forecasts for the coming six months:

Asset allocation

Given our gloomy scenario outlined above, the key investment aim we strive for will be capital preservation for some time to come. We will invest in well run companies in defensive sectors, which we think will be able to maintain their relatively high profitability, albeit at a modestly reduced level. Because of uncertainties and lacking opportunities, such companies will not really know what to do with their cash. Thus they will use it to further reduce their debts and to fund sustainable high payout ratios to shareholders.

Emerging markets, many of which have been in excellent shape up to now and many of which are undervalued, are nevertheless no investment alternative in the current environment, as all world markets will undoubtedly be contaminated by the debt crisis devastating mature markets. Moreover there is a considerable currency risk in some of these markets.

To round up our asset allocation, we will add some gold and commodity picks to our portfolios.