Politics and finance have always been closely linked - a connection noted, in fact, since modern economic study began when Adam Smith penned The Wealth of Nations in 1776.
Yet 2012 was a year in which investors were paying more attention than usual to the machinations of the political world. The prospect of new leadership in several major G8 economies added another dose of uncertainty to an already confusing backdrop, where solutions to the many destabilising economic problems facing the global economy remained elusive. And, after a turbulent 2011 that saw serious upheaval in many Islamic states, investors were braced for the prospect of another year of ups and downs, even if they weren’t quite sure where those ups and downs may come from.
As it happened, they ultimately shrugged off these worries, and most markets around the world powered to pre-crisis levels in 2012. The recovery of the US economy blazed the trail, helped along by the intervention of its central bankers and their counterparts on the other side of the Atlantic acting to prevent meltdown in the eurozone. European Central Bank chief Mario Draghi promised that he would do "whatever it takes" to prevent the collapse of the euro, and he kept his word.
And, although China appeared caught between a rock and a hard place - unwilling to deliver new stimulus for fear of stoking another capital investment bubble, and yet keen to avoid a so-called hard landing - its new leadership appear to have reassured the market that they, too, would do whatever it took to keep growth in the Middle Kingdom on the right trajectory, albeit one led by a push towards consumption rather than the infrastructure investment that drove a 20-year boom.
Misplaced confidence
So, as we enter 2013, there exists a prevailing sense of optimism that, nearly half a decade on from the greatest financial crash the world has ever seen, the global economic nadir is behind us. The end-of-year predictions landing in my inbox are overwhelmingly bullish. John Ficenec has outlined a selection in 'Where will the markets end in 2013?'. Perhaps it is time to remember the mantra that when the last of the bears has been smoked out it is time to run for hills. Certainly, the extent of the hard work left to do should not be underestimated, and there are, as yet, few convincing answers to the really big questions still on the table. As we go to press, it looks as though America will reach a last-minute resolution to its looming fiscal cliff - given that this is exactly the outcome predicted, and will avoid recession in the US, it is surely baked into market forecasts. And the billions of fresh money being pumped into its system are hardly indicative of a burgeoning recovery, especially when the US debt ceiling is likely to be raised yet again.
And, while the eurozone may have avoided catastrophe on several occasions this year, the economic bloc remains an investment Babel where a new problem emerges as soon as another is seemingly resolved. Big questions still hang over the health of France and, in the wake of its latest leadership fiasco, Italy. And elections in Germany will undoubtedly have enormous repercussions for how Europe's strong man intervenes in the continent's continuing crisis - in short, its voters don't want to pay for the profligacy of its southern European neighbours, and politicians won't want to alienate them by continually bailing out the periphery. Europe's political problems are far from over.
While the pressing concerns of bankers may have been addressed by LTRO and QE, such mechanisms have done little to address problems on the ground, especially in Europe, where economic growth remains elusive and unemployment is stuck at elevated levels. The quest for banking union in Europe remains at the forefront of its politicians' minds - because this, they believe, is where the largest risks to economic stability lie - but what its people want is reassurance that growth will return and austerity will be consigned to the scrapheap. As a recent paper from the McKinsey Global Institute argues, Europe's policy debate "has focused more on how to balance public budgets than how to reignite growth". A shift in direction is long overdue.
Where's the growth?
Of course, economic growth and markets are only correlated, as plenty of analysis has discovered, in the loosest of ways, if at all. That's especially true of the London markets, whose residents conduct much of their business internationally. And GDP does not reflect the profitability or indebtedness of companies, far more important determinants of valuations than sales growth. As they say, revenues are vanity, profit is sanity, and even if sovereign balance sheets are little improved, the same cannot be said of many companies, who over the past four years have trimmed costs to keep profits ticking up to record levels. And markets do not fall when profits and profit margins are rising.
But there must come a point at which stuttering economic growth both at home and overseas affects companies' ability to grow profits further. Seeking efficiencies can only take profits so far - sales growth must now follow if profits are to progress further, and that is undoubtedly dependent on wider economic performance. As the McKinsey Institute notes, it is not government intervention but substantial increase in private investment that is needed to drive a meaningful recovery in economic growth.
Indeed, part of the reason that companies are in such good shape is that, in the wake of the economic crisis, they stopped spending. As McKinsey notes, private investment fell by more than four times the rate of real GDP between 2007 and 2011, and means listed European companies are sitting on excess cash of €750bn. The same is true in the US - its companies are said to be sitting on close to $2 trillion. As we explained in the issue of 23 November, that could lead to an almighty M&A boom in the year ahead, which in turn could provide a short-term boost for some equities, but remember that history tells us that large-scale M&A also has a tendency to be value destructive.
Signal failure
The strength of corporate balance sheets isn't necessarily a sign of strength, either - it could instead mean that executives remain unconvinced that the growth is there to justify major investment. And, as Chris Dillow explains in 'The economy in 2013', a lack of corporate spending also leads to economic weakness - an especially vicious circle, and one which makes it all the more surprising that the US economy has been so strong, given the lack of spending there, too. Private investors seem to share that sentiment, as demonstrated by simultaneously rising gold and gilt prices - havens of wealth preservation rather than wealth creation. The irony, of course, is that there is nothing to suggest that dangerous bubbles cannot form in safe havens, too.
And if, below the bullish façade of the fund managers peppering hacks with 2013 predictions, confidence in the real world is in short supply, the implications for stock markets could be profound. While the relationship between economic growth and stock markets is loose, the relationship between stock markets and confidence is much clearer: when it evaporates, they tumble. "This market right now is moving on nothing more than emotions. Guess what? It almost always moves on emotions," once said American financial writer David Bach. And the overwhelming emotion at the moment is fear, even if the recent direction of markets suggests otherwise.
While QE and its ilk have driven demand for risk assets, as Simon Thompson points out they have also created a situation where investors seek out risk-free assets in ever greater numbers. And those safe havens will be increasingly hard to come by in 2013, as yields on high quality assets continue to contract. As Stephen Wilmot explains in 'UK property: An age of extremes', in the world of property this means that the yield gap between primary and secondary properties is wider than at any point in recorded history. But does this mean A-grade properties are overvalued, or less desirable ones undervalued?
The same question can be asked of equity markets, where the allure of defensive income-bearing shares has seen valuations rocket and dividend yields move in the opposite direction. BAT springs immediately to mind - its share price has doubled in four years, and although it's still paying out a decent dividend of around 4.5 per cent, you're paying a handsome 15 times forecast earnings for that, well above the UK market average of 12.
So, while the first half may, as Simon Thompson suggests, deliver a technical rally we'd still suggest that investors take a far more prudent approach to their activity next year - and that means taking a value-led stock-picking approach rather than buying into the hope of a recovery that might not come.
As fund manager Nick Train told us this week, it is often better to trust the company, not the market.
