By Mike Franklin, Head of Investment Strategy, Beaufort Equity

Starting out into the new year, the investment prospects may remind many investors of the old saying ‘When you’re up to your neck in crocodiles, it’s easy to forget that you set out to drain the swamp!’.

There are two already two potential flashpoints that investors will need to be braced for.

1) North Korea, which has nuclear capability, has a new leader with yet-to-determined national and foreign policies.

2) The stand-off in the Strait of Hormuz between Iran and the United States which has prompted a spike-up in the oil price on the threat to supplies.

While these situations have the potential to destabilise market sentiment, a more immediate threat continues to come from Europe as successive Sovereign Debt refinancings highlight the on-going challenges to the integrity of the Eurozone.

However, these are almost certainly not the only areas of potential risk, putting aside the possibilities of further social and economic disruption that La Nina or other natural phenomena may wreak in the coming months. Against this background, investors can be expected to continue to proceed with great caution as this year unfolds. Consequently, the short term trading investment mentality — and accompanying volatility - that characterised 2011 looks likely to carry over into 2012.

In the United States, where Democrat-Republican stand-offs are undermining much-needed initiatives on several fronts, much of the news will be dominated by the Presidential Election campaign up until the result is known in mid-December 2012. Meanwhile, the flow of monthly data suggests that the economy is finding increasing traction although the key challenges remain unemployment and the housing market. Critically, some companies are achieving respectable rates of growth and, indeed, some are using accumulated funds to buy back their own stock. However, an estimated US$ 1 Trillion-plus is still parked in corporate accounts pending deployment once there is sufficient confidence in the strength of the economic recovery.

The prospects for China in 2012 depend heavily on how effectively the policies of the Government and the Central Bank cope with the structural problems that are becoming apparent in some parts of the economy. Emerging difficulties in the property sector along with evidence of the breakdown of normal business finance, as surfaced in Wenzhou/Zhejiang in 2011, are adding to China’s challenges just as its export growth - particularly to Europe - is slowing.

In Europe, the challenges have been well-documented. The flourish by the European Central Bank that produced almost €500 million of new three-year lending for banks in the Eurozone in late-2011 came in the face of tightening credit conditions. It remains to be seen to what extent this additional liquidity serves to ease the pressures on European Governments as they attempt to refinance their debt in 2012. Indeed, some countries may not be able to survive within the Euro framework much longer. If there are any defaults, it has to be hoped that these will be orderly for the sake of confidence in global financial markets. The prospect of compromised economic activity will be a problem not only for the Eurozone countries but for many of the EU member states, including Britain.

Looking beyond the potential problems, there will be opportunities to make investment profits in 2012 but, as in 2011, this will require a flexible investment approach to harness the volatility arising from the switches in sentiment between confidence and fear as the year’s news emerges.

During 2011, there continued to be a high level of correlation in the movement of several major market indices such as the S&P 500 and the FTSE 100. These can be expected to try to move a little higher before falling back in the next few months. In contrast, having been in a broad downtrend since April 2011, the Shanghai market is looking to be close to a bottom on a technical basis despite the difficulties facing the China economy at present. In part, this may reflect speculation that the Central Bank is close to announcing another cut in the Reserve Requirement Ratio for banks, perhaps ahead of Chinese New Year later this month.

Given the foregoing scenario that further volatility is to be expected in equity markets in 2012, investors will need to maintain a reasonable level of liquidity to be able to ‘play the cycles’. Inevitably, portfolio exposure to bonds is vulnerable to eventual improvement in the economic outlook around the world and the prospect of rising interest rates. While the timescale on this is difficult to gauge, it does not look to be imminent. Although there are encouraging signs that the US economy is beginning to recover, there is still speculation that the Federal Reserve may yet implement further Quantitative Easing measures which is not helpful for the Dollar.

Subject, of course, to investment guidelines on portfolios, the centre of gravity should begin to be shifted towards greater equity exposure. However, a trading mentality for part of the portfolio will still be appropriate. With regard to the positive call on the Shanghai market, we recommend that initial exposure be gained through Exchange Traded Funds (ETF’s).

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