During December stock markets attempted their traditional Christmas rally and made positive progress in the UK and US, but failed in Europe. The FTSE 100 index finished with a positive month of 1.2% improving what was a poor year, down 2.2% in total return terms. The US market actually rose in total return terms over the year as a whole, whilst Europe suffered severe falls of around 16% in euro terms. These figures clearly highlight the dominant theme of the year, namely Europe, which caused elevated volatility and a spike in stock correlations, particularly over the past six months.
We suspect that 2011 will have proved a tough year for many investors and portfolio strategies. The extreme risk-off episode we saw in early August, followed by the risk-on/off reaction to policy announcements will have presented a challenging environment for “alpha” generation, and will no doubt have caused some market timing issues. We have talked about correlation between stocks spiking up to extreme levels, but we also observed that correlation across some asset classes rose, making real diversification harder to achieve in a portfolio context. Against that background the AI UK Equity Market Neutral Fund (“the Fund”) has delivered a positive return of 3.3% for the year, with December adding 0.34% (figures are gross of fees, in sterling terms). Equally important to us is that the Fund continued to demonstrate its low volatility and market neutral characteristics in highly stressed markets. We hope that the Fund’s low correlation with other asset classes has helped it provide to real diversification benefits in our investors’ portfolios.
Macroeconomic policy error contributed to a slower pace of recovery than anticipated at the start of last year and led to cuts in forecast GDP growth throughout the globe. These have been more severe in Europe as governments in peripheral economies found it increasingly hard to borrow against a background of credit rating cuts. As we stand, the outlook is for a slower but continuing recovery in the US, slower growth in emerging countries and a recession in Europe. The UK faces an anaemic year in terms of growth, but this could potentially end stronger with prospects for 2013 starting to turn up. The real issue is one of confidence and European bureaucracy has thwarted progress on this front. As in all crises, timeliness is of the essence and thus central to all our current forecasts is an assumption that a solution is achieved sooner rather than later.
The dash to safety has had some bizarre but encouraging consequences. In the US and UK government borrowing costs are at all time lows, despite stretched finances, giving the impression that target reductions in debt levels will be hit. These economies therefore end up being relative winners, and this has been reflected in much better equity returns. Loose monetary policy and tight fiscal policy will remain in place for some time and should encourage private sector investment as confidence returns. For now, we continue to await further progress and could well see an extreme spike in volatility before a solution is achieved, which necessitates a cautious approach. We are hopeful that elections in France, Germany and the US will provide the motivation to put in place a policy that serves to calm markets and improve sentiment. If not, then markets will likely force the agenda upon them
Our approach has always been pragmatic, focusing on preserving capital when markets fall and not attempting to call turns. In the second half of 2011 our activity became more tactical as stock fundamentals and qualitative characteristics took a back seat in the macro-dominated risk-on/risk-off environment. Midcap stocks suffered their worst period since 2008, underperforming the FTSE 100 by 13% and now look extremely oversold. Having said that, in December a position in Collins Stewart, a mid tier stock broker received an approach from a Canadian rival, Cannacord. Our analysis revealed the market had ignored any value in Hawkpoint, the M&A advisory division of Collins Stewart and we were happy to invest in a company which had substantial liquid cash resources on the balance sheet. Cannacord clearly shared our view. We had hedged the position with FTSE 250 swaps. Also in December, positions in Stagecoach and Go-Ahead performed well relative to the consumer hedge we had in place, reflecting better earnings revisions.
We have made progress developing our European exposure with positive contributions in both December and over the year as a whole. Trygvesta, a Danish insurance business has been a good performer; insurance doesn’t tend to be too cyclical and pricing is firm.
The company has a policy of returning excess cash to shareholders, so the stock has a good yield. We hedged this position with market instruments. In the pharmaceutical sector we had a relative value trade between Novartis and a Finnish healthcare stock. Novartis traded at a large discount despite a strong product pipeline. Following a good run for the position we have now replaced Novartis with Bayer where short term newsflow looks stronger. The Finnish stock has been supported by retail interest but trades on an expensive valuation and has an inferior pipeline to many of the other European pharmaceutical companies. Furthermore, its relatively high dividend may not prove sustainable.
As in previous years we have used the risk aversion of the November and December period to increase positions where the trading updates have been good, so positions in Paragon and Moneysupermarket have been increased.
The main catalyst for putting more capital to work will be falls in volatility and stock correlations. As mentioned above, markets are likely to accelerate events if politicians continue dragging their heels so we shouldn’t have to wait too long.
Please note the value of investments and any income from them will fluctuate and is not guaranteed (this may be partly due to exchange rate fluctuations). Investors may not get back the full amount invested.
