2013: What's hot, what's not

By Tim Condon

ING senior economist

The fourth quarter of 2012 was a good one for risk assets. But unlike all the other post-global financial crisis (GFC) good quarters it wasn’t due to markets re-pricing for increased US monetary accommodation. The third quantitative easing (QE3) ended the go-stop U.S. monetary policy responsible for the post-GFC swings between risk-on and risk-off investor sentiment. We ascribe the fourth quarter rally in risk assets to “good enough” economic fundamentals. Unlike the earlier risk-on rallies, not all risk assets are created equal when economic fundamentals matter.

We expected the change that occurred with the announcement of QE3 to happen earlier. A year ago we identified policy uncertainty, especially regarding US monetary policy, as the main source of swings in investor sentiment. We expected policy uncertainty to fade as investors became accustomed to new-normal economic fundamentals in the advanced economies. Reduced policy uncertainty would leave economic fundamentals to drive risk asset performance and they were good enough for risk assets to rally.

Our expectation of how quickly this mindset shift would occur was overly optimistic. The performance of financial assets in the first three quarters of 2012 followed the same pattern that had prevailed since the GFC. “Grexit” fears reversed risk-on sentiment in the second quarter of 2012 and re-pricing for QE3 restored it in the third quarter. But QE3 was different. Rather than reverse falling inflation expectations as previous QEs (and operation twists) had done, QE3 supports them.

Because the conditions we expected would prevail all year, they only materialized after the US Federal Reserve announced QE3 on September 13, so we considered the fourth quarter pattern of financial asset performance a good test of our predictions a year ago for 2012. We expected emerging market equities to outperform developed market equities on a “the-riskier-the-better” view. We expected both to outperform emerging market debt on the view that good-enough economic fundamentals implied well-supported US Treasury yields, which would be a headwind to credit.

We believed a strong U.S. dollar, ING’s house view, would be a source of depreciation pressure on Asian currencies but we expected capital inflows into equity and fixed income markets to be enough to drive modest appreciation in 2013. We couldn’t identify any such offset in the case of gold and we expected it and U.S. Treasuries, the risk-free asset, to be the worst-performers in 2012. China hard-landing subsequently led us to change our view that emerging market equities would outperform developed market equities.

We shouldn’t have changed our view. Emerging market equities were the top-performing asset class in the fourth quarter, returning 7.4 percent. They were followed by developed market equities at 2.1 percent, emerging market debt at 1.3 percent, Asian currencies at 0.9 percent, U.S. Treasuries at minus 2.4 percent and gold at minus 5.5 percent.

We expect some changes in the rankings in 2013. We no longer fear a hard landing in China. Firmer export growth after an unusually weak third quarter and the acceleration in retail sales growth starting in the third quarter are evidence that the authorities managed a soft landing from the 2011 monetary tightening. Reduced political noise following the successful transition to the fifth generation leaders is another positive. We now expect emerging market equities to outperform developed market equities.

ING’s forecast that the US dollar will appreciate against major currencies in 2013 implies a headwind to the performance of Asian currencies. Our house view has the Euro depreciating 10% against the US dollar to 1.20 by end-2013 and the Japanese Yen depreciating 11% to 95. The tailwind will come, as in 2012, from hot money inflows into Asian financial markets. However, several Asian currencies appreciated a lot in 2012. We expect greater resistance by their central banks in 2013 to result in less Asian currency appreciation than in 2012, when the Asian currency index rallied 3 percent.

The link between the return on gold (and other commodities) and the US dollar is obvious; commodities are priced in US dollars. A year ago we thought gold would rally in the event of a market panic. Its failure to rally during the Grexit panic in the second quarter of 2012 makes us doubt the panic case for gold. We also doubt the inflation case. Gold rallied ahead of the announcement of QE3 on the hope that it would resemble QEs 1 and 2. It retraced when investors appreciated that QE3 was different. We think QE3 supports inflation expectations. It would have to raise them for there to be an inflation case for gold.

The yield on the 10-year US Treasury rose 14bp to 1.76 percent in the fourth quarter. ING forecasts it rising to 2.1 percent in 2013, an increase of nearly 30bp from the prevailing level, which we see causing US Treasuries to underperform gold in 2013. Rising US Treasury yields also will be a headwind to the performance of credit, enough of one, we think, that emerging market debt will underperform the Asian currency index this year.

Our ranking of assets in descending order of expected 2013 performance is emerging market equities, developed market equities, Asian currencies, emerging market debt, gold and US rates.