We may well look back on 2011 as a year that forever changed the economic and political landscape of the world.
At the very least, it will be a case study year for students of both economics and politics long into the future. For this year proven no less eventful than 2008, with a bombardment of sensationalist headlines causing unprecedented volatility across the financial markets. Indeed, during one tumultuous week in August, the S&P 500 Index gyrated by more than 4% on four consecutive trading days – movements of such magnitude have never been witnessed before.
We saw several sovereign states in the Eurozone being forced to count the cost of many years of living the high life through soaring interest rates and further bailouts for Greece and Portugal. With tough austerity measures being thrust upon the high debt nations we saw a change of government in Greece, Italy and Spain as financial markets flexed their power over political leadership. However, the Eurozone debt crisis was far from the only macro-economic event clouding the decision-making process of investors. On the other side of the World, the US suffered the embarrassment of being stripped of its AAA credit rating.
With this deluge of macro headlines dominating the fundamentals, correlations between asset classes and intra-asset class rose sharply. It was a year where valuations clearly counted for very little and certain markets were driven to extreme levels. Through 2011 gold and UK gilts were the asset classes of choice. For those unwilling to buy these areas, life last year was undoubtedly tough as almost everything else lost value.
Investors started the year in an optimistic mood as risk assets marched higher in
the first quarter on the back of strong earnings growth, with around 70%
of companies in the S&P 500 Index reporting profits ahead of expectations.
While developed market equities were able to make good progress, emerging market equities underperformed. With major commodities priced in dollars, the price of metals, foods and energy spiked, causing high inflation in those economies, requiring policy makers to take action and stamp on the brakes by tightening monetary policy.
By April, the relative calm of the first quarter was a distant memory and the
so-called ‘Arab Spring,’ intensified. Peaceful demonstrations were replaced with a revolutionary tone, turning into all out civil war in Libya. This led to a further spike
in the oil price to above $120 a barrel, a level that hindered global economic growth in the second half of the year.
Bond markets were quick to react to the changing macro picture with sovereign bond yields in the perceived safe havens with UK gilts and German bunds plunging to historical lows. On any normal valuation metric these looked widely overvalued, offering negative real yields for much of the year. However, these are unprecedented times, where policy measures and fear override fundamentals. In the UK, the Monetary Policy Committee appeared to have largely abandoned its dual mandate of price stability and growth in favour of simply the addressing the latter. A further round of quantitative easing in the UK was unleashed.
Equity investors appeared to have their head in the sand during the second quarter, taking comfort from continuing positive earnings momentum rather than paying attention to deteriorating macro news. This all changed in August in what turned out to be a brutal month for risk assets. Finally, equity investors could appreciate bond investors’ fears. With the Eurozone sovereign debt issues at the epicentre of global risk, the first eight trading days of August saw Germany’s Dax index tumble 15%, with many other global equity markets posting similar double-digit losses.
Heightened levels of volatility persisted. After two big down months in August
and September, October represented the best monthly gain in the S&P 500
Index in 20 years. However, as we moved towards the year-end, the Eurozone debt crisis further intensified and despite a number of planned ‘rescue’ packages, contagion continued to spread from periphery Europe towards the core.
We expect the performance of financial markets in 2012 will once again be
heavily influenced by policy rather than fundamentals. However, it is unlikely to
be such an influence as we saw in 2011 with much uncertainty already priced into markets. There will come a point when the fundamental argument of valuation will reassert, when asset prices are no longer driven solely by global macro-economic news. We are not there yet, but with many asset classes reaching valuation extremes, we may not be far off.
