Cyprus represents 0.2% of the eurozone economy, so the amount of bailout money required for it to avoid defaulting on its debts was never a major economic problem.  However, it has posed significant political problems, not least because many Northern European nations saw the Cypriot banking system as profiting from black money from Russia and elsewhere, and therefore less deserving of rescue.  The crisis has underlined that, though the euro is the currency of one of the two largest economies in the world, its economic policies are driven by politicians of what are, in global terms, rather small economies, who do not appreciate the wider implications of the decisions that they make.

Until last summer, the euro crisis was spiralling out of control as banks with poor asset bases required government bailouts from governments, which themselves were struggling to raise money to fund their deficits.  The capital that was injected into the banks was then invested in government debt of the home country because (i) it was the patriotic thing to do and (ii) the yields on offer were very attractive.  Thus weak bank finances created weak government finances which further weakened the banks.  At the July EU summit last year, a major breakthrough seemed to have been achieved when it was agreed to try and stop this vicious circle by using the ESM to directly recapitalise weak banks, in a way that this would not be a liability of the national government.  In addition, it was agreed that the eurozone needed a full banking union in order for the monetary union to work.

This analysis was sound.  However, by September Germany was backtracking on this agreement, and now does not support using ESM money to recapitalise banks, insisting that this is a matter for the individual country to sort out.  Further, one of the fundamental elements of a banking union is a Europe-wide deposit guarantee insurance programme, and here again Germany has insisted that this is the responsibility of the individual country.  The political will in Germany to provide money for more bailouts has declined markedly since last summer.  It should also be noted that Cyprus did admit at the height of the crisis, that it did not have the money to honour its deposit guarantee scheme – this is also likely to be true in several other weaker economies.

A crisis in the next few months, ahead of the German elections would bring together the “austerity fatigue” that is evident in many Southern European countries like Greece, Spain and Portugal with the “bailout fatigue” that is evident in Northern European countries like Germany, Finland and the Netherlands.  It could thus be that the tiny Cyprus bailout debacle is the first in a chain of events that leads to the end of the euro.  The withdrawal of deposits from weaker banks in the weaker countries could lead to bank failures which require their governments to recapitalise them with money that has to be borrowed, pushing up their bond yields and creating another sovereign debt crisis.  A similar tough approach from the Northern European countries, to that they adopted with Cyprus, could set the terms of a bailout so high that the debtor countries will not accept them and instead choose to exit the Euro.  It will be the peoples of these countries, rather than the politicians, who make this happen.

The investment conclusion is to remain very wary of most euro-denominated investments until a more sustainable monetary system is in place in Europe.

Since the crisis, all three of these conditions are being severely tested, causing increasing angst to many in Germany.  With regard to the first condition, it is currently true that no country has been bailed out by transfers from the other countries. However, Greece has stretched this interpretation to the very limit.  Huge amounts of money have been lent to Greece by the IMF, the EU and the ECB (and so not directly by other countries), which are officially repayable.  All non-official holders of Greek debt have had their arms twisted to agree to their holdings being substantially written off.  Most investors expect the official holders also to agree to write-offs (at which point the money is no longer lent but in reality given), but this will not occur until 2014, after this year’s German elections.  Germany’s first condition (no bail outs) will be breached next year.

Under its first two Presidents, Duisenberg and Trichet, the ECB did, in fact, model itself heavily on the Bundesbank in its operation of monetary policy. Draghi, however, took over at the height of the crisis.  His first act was to provide a trillion euros of extra liquidity for weak banks from the peripheral countries, in exchange for collateral of very dubious quality, a tactic which drew criticism from the Bundesbank, but great acclaim from most other quarters.  Then last summer, as Spain appeared to have lost the confidence of markets to issue its debt, Draghi invented the concept of Outright Monetary Transactions, which permitted the ECB to intervene in government bond markets to an unlimited extent. The Bundesbank, saw this (rightly) as tantamount to the printing of money, as was being practised in the US, Japan and the UK, but was the lone vote against within the ECB Council.  Crucially for Draghi, Merkel decided to over-rule the Bundesbank and gave Germany’s blessing to this very un-Bundesbank action.  Germany’s second condition has already been breached.

The third condition is the one which matters most, and which Germany will least be prepared to see breached.  To emphasise the point, Germany has brought forward its draft of the 2014 budget, demonstrating that it continues to cut government spending to meet its target of a balanced budget in 2015.  The message to the rest of the eurozone is unambiguous – they too must meet their promises of cutting government spending to achieve balanced budgets in the medium term.

The forthcoming EU summit will contain no Italian government, following the post-election stalemate in which over half of the voters voted for parties which explicitly rejected the EU-led austerity programme initiated by Monti.  The French government has just announced that it now expects a deficit of 3.8% of GDP this year, compared with its EU target of 3.0% – it seems unlikely that President Hollande will make any great attempt at further government spending cuts.  In Greece, the latest tranche of official loans is dependent upon clear plans for Greece to cut 150,000 civil servants from its headcount in the next eighteen months. Greek politicians are very reluctant to agree and even more reluctant to implement such plans.  Both the Spanish and Portugese have promised their people that they have had the last round of cuts, but their budget deficits remain too high due to the continuing recession in these countries.

Austerity in the Mediterranean countries is reaching its political limits.  If Germany continues to insist on its third condition (the control of budget deficits) as Merkel will want to be seen to be doing ahead of her election in October, then the possibility of a country falling out of the euro in the short term is once more very real.  In the longer term, even if Germany gives a little ground now, it will continue to insist on governments reducing their budget deficits at a rapid pace that will mean little or negative growth in many eurozone countries for years to come.  This price will prove too high for some economies.

The investment implications of this are to maintain low exposure to euro-denominated assets until more reflationary policies are being actively pursued in the euro area – if Germany continues to stand on its principles, this may be never.

On fiscal policy, the coalition government has been and remains totally committed to reducing the budget deficit by a planned, slow but steady austerity approach.  This initially involves an increase in taxes, followed by spending cuts throughout the life of this parliament and now extended well into the next parliament.  Unfortunately, for the UK economy, this well-planned and thoughtful approach has not delivered the budget deficit reductions that were predicted for two main reasons as follows:

• the eurozone crisis meant that the domestic economy of our nearest and largest trading partner was much weaker than expected as even more severe austerity was introduced there than in the UK.
• all the economists’ models of how an economy performs at a time of government spending cutbacks woefully underestimated the impact of austerity on the overall economy.  The result has been considerably weaker UK economic performance, and much higher budget deficits than forecast by the government.

None of the Chancellor’s choices on fiscal policy are politically appealing.  Should he choose:

• to cut spending faster than planned, to try and meet the deficit targets in future years, then even more public sector workers will be put out of work in the run-up to the next Election.
• to reverse the spending cuts, then he will be accused of admitting that the austerity policy was wrong all along.
• to do nothing, then he will be accused of having no ideas to boost the economy.  Increasingly, with a little over two years to go until the election, these accusations are likely to come as much from his own MPs as from the Opposition.

With regard to monetary policy, Mervyn King, the current Governor of the Bank of England, has managed to thoroughly confuse everyone. For the last twelve months he has been saying that the policy of Quantitative Easing (in place since April 2009) is becoming progressively less effective and that monetary policy cannot solve all the UK’s economic problems.  This is somewhat at variance with his confidence in the policies when they were initially unveiled.  However, the latest minutes from the Monetary Policy Committee showed him in a minority of 3 (against 6), voting for more QE to stimulate the economy at a time when inflation is expected by the Bank to be above its target throughout the next two and a quarter years.

Further, the Chancellor, has asked the incoming governor to lead a debate to assess what the appropriate target of monetary policy should be.  Taken all together, one gets the distinct impression that those in charge of UK economic policy have run out of ideas.

The investment implications of this uncertainty and indecision have already begun to be seen.   Gilt yields have been rising, and sterling has been falling, evidence that international investors have been reducing holdings of UK government bonds.  A weaker pound is however positive for the profits (in sterling terms) of many of the UK’s largest companies, and so share prices have been rising.  The rise in government bond yields is likely to be mirrored by rising sterling corporate bond yields, and exposure to this asset class should be reduced.

The turn of the twentieth century was when this title last changed hands, when it moved from the UK to the US, and in the following decades the more populous and faster-growing economy (then the US) meant that it became a more and more powerful force in the world economy, culminating in its currency becoming the world’s primary reserve currency.  This status accords a huge advantage to the holder, in that there is an underlying demand from all other nations to hold the reserve currency in order to maintain the ability to trade.  This has been clearly visible for the US, as the dollar makes up the largest proportion of foreign exchange reserves, and most trade in commodities is conducted in dollars.

The dollar is not going to lose its reserve currency status overnight – the yuan is not yet freely convertible and today barely features in the international financial markets. However China’s stated ambition is that it will become the world’s primary reserve currency and take on that role from the dollar.  Since 2005, however, China has slowly but steadily been internationalising its financial markets by (i) allowing more foreign exchange trading, (ii) the issuance of yuan-denominated bonds and (iii) giving more access to foreigners wanting to invest in China’s stock markets.

Just as London maintained its presence as an important centre for financial markets as the US economy and New York overtook it in the twentieth century, though losing market share, so in the this century will Asia and China become the key centre for financial markets.  Success in the investment world in the next few decades will require substantial exposure to Asian markets and an increasing understanding of the impact of Asian economic policies and decisions on our own economy and markets.  We maintain a heavy commitment to Asian equities in portfolios.

Productivity is defined as total output divided by the amount of labour used to produce that output.  It is increasing productivity that produces the increases in the standard of living within an economy.  Historically, productivity growth in the UK economy has averaged about 1.5% per annum, but over the last ten quarters, the UK’s productivity has been averaging minus 1.5% per annum – indicating that the overall standard of living in the UK is declining.

Two sectors in particular account for much of the fall in productivity.  First, North Sea oil output has been in decline for some time now, and requires more effort and resource to produce that declining output.  Secondly, the banking sector (which delivered dramatic productivity growth before 2008) has seen a dramatic fall in output, with little change in total employment.  Many highly-paid bankers have lost their jobs, but the banks have had to hire just as many people in the compliance, risk and legal areas to deal with the aftermath of the banking crisis.

It is also undeniably true that the UK labour market has become very flexible with many businesses making much more use of variable pay structures through bonus systems, meaning that labour costs can be initially lowered by reducing the variable element of compensation, rather than immediately reducing the size of the workforce.  There are also many examples of businesses where workers have agreed to lower wages and benefits, to maintain their jobs.  Average wage growth in the UK has been below inflation for the last four years, so real wages have been falling steadily.

The statistics of the numbers of people employed also show a steep increase in the numbers of self-employed.  However, many of these are actually working very few hours, and so the official data show them as employed but in fact with very little economic output.

Elsewhere, surveys indicate that there is a degree of labour hoarding going on within companies, who fear that by reducing their workforce, they may lose key skills that they might not be able to replace in an upturn.  This however becomes progressively more difficult to maintain as time passes.  It also acts as a potential overhang to the unemployment rate and restrains business and consumer confidence.

The paradox of a job-creating recession reinforces the views and sentiments that were set out in our 2013 investment outlook: 2013 – Limited Growth and New Monetary Policy Regimes .  The UK economy is likely to continue to struggle in 2013.  However, the combination of (i) a governing coalition in the second half of its life and needing some positive economic news, and (ii) the summer arrival of a newly-imported Governor of the Bank of England, who is generally regarded as being much softer on inflation than Lord King, could well lead to a new direction in economic policy, which would bring long-term inflationary consequences.  We continue to recommend positions in index-linked gilts and gold for most investors, to act as a portfolio insurance policy against these inflationary possibilities.

For Messrs. Osborne and Cameron, this will undoubtedly be politically embarrassing.  When they first came to power, they laid great store on the credibility of their austerity policy with the financial markets and the credit rating agencies.  Since then, they have often sought to justify the policy by reference to the fact that the AAA rating has been maintained to date, while most Eurozone countries undergoing austerity programmes have seen their ratings reduced.  The Labour Party will be able to score many political points, if and when a downgrade occurs.

For the financial markets, and indeed for the economy, it will, however, be of almost no significance.  Markets are rarely surprised by downgrades to credit ratings, as the agencies telegraph their thinking some months ahead.  Both the US and France have already lost their AAA status with at least one of the agencies, and it has had no obvious effect on yields on their government bonds.  Indeed, French yields have fallen sharply since being downgraded.

For countries such as the UK and US, which have Central Banks who are allowed to print their own currencies, there is in fact no doubt that these governments will always repay their debts.  They always have the power to create the money that is necessary to repay any debt denominated in their own currency.  From the perspective of a domestic investor, there is no risk of not being paid back the nominal value of any government bond, and in that sense they should remain AAA.  That is not of course the same thing as saying that these bonds have no risk, since creating a lot of money to repay government bonds is likely to prove very inflationary.  Being repaid in devalued money can seriously damage an investor’s wealth.

For countries inside the Eurozone, matters are very different.  By adopting the single currency, they have forsaken the right to be able to create the money to repay their debts and handed the right to the ECB, who hold a very strong conviction that creating money for such reasons is a very bad idea.  It is thus entirely possible for a Eurozone country to find that it does not have enough euros to pay back its lenders, and thus go into default – hence the crises in Greek, Portugese and Spanish debt markets in the last few years.

One investment implication is likely to be a reversal in the strength of sterling that was seen in 2012, when it was the strongest of the major currencies over the year.  Any downgrade itself is not likely to be the cause of sterling weakness, but both would reflect the poor growth performance of the UK economy.   Further, David Cameron’s recent call for an in/out referendum on the UK’s membership of the EU, will create much uncertainty in the minds of global businesses and investors looking to invest in the UK.  The pound looks set for a period of weakness, and investments overseas should benefit from currency gains for UK investors.

With a balanced budget, near full employment, and a trade surplus of 7% of GDP, Germany is ideally placed to pursue policies designed to boost German consumer incomes and spending, which the rest of the Eurozone could supply.  Yet, aside from some very modest pre-election tax cuts, which have already been announced, there is no indication that German politicians wish to go down such a road.

This is for two reasons.  Firstly, they take the view that the reason for their economic success is precisely because they have not, historically, pursued such short-term stimulatory policies, but have instead concentrated on ensuring they have globally competitive private-sector industries and a structurally balanced public-sector budget.  Secondly, the German Finance Ministry has realised that in the next few years they will need to provide funds to meet their obligations to the EFSF and the ESM, which have been set up to provide the bail-out monies for the weaker countries. They are thus already planning for offsetting public sector spending cuts in 2014 and beyond – in sharp contrast to all other countries, who are hoping further bail-outs won’t be needed, or will seek to borrow the funds from the markets if they are.

So, domestic spending is unlikely to be driving the German economy in the near future.  As usual, Germany will be hoping to benefit from global demand for its exports. Here though, the actions of the ECB and Japan may thwart those hopes.

Despite the Eurozone sliding back into recession, at its last two monthly meetings, the ECB has not cut interest rates when many commentators thought that it could and should have done.  Indeed after the last meeting, Mr Draghi made clear that the ECB had done as much as it could to promote growth, and it was now the role of governments to produce pro-growth policies.  The markets interpreted this as saying that no more rate cuts or easing of monetary policy would be forthcoming, in contrast to the $85bn each month of QE from the Federal Reserve.  Since then the euro has been the strongest of the major currencies, making German exports less competitive.

In Japan, the focus of the new government to stimulate the economy by all possible means including weakening the currency has seen the yen fall sharply in recent weeks.  Against the euro the yen is 20% weaker over two months and 26% weaker over six months.  These are dramatic moves for any major exchange rate, but the euro-yen exchange rate is particularly important for Japan and Germany.  This is because their strengths are in very similar industries, and competition is hard-fought in sectors such as automobiles, power plants and high-technology capital goods.

In early 2009, the exchange rate was 140 yen to the euro, and over the next 3 years the yen strengthened to 95 yen to the euro, making Japanese companies very uncompetitive against European (but most importantly, German) companies. German exports performed very well in 2010 and 2011, particularly to China.  This was also helped by a diplomatic row between Japan and China about sovereignty rights over some small islands lying between their two countries, sparking popular anti-Japanese sentiments inside China, and consumer boycotts of Japanese goods.

Japan is now deliberately weakening the yen further to stimulate their economy – the recent 20+% fall in the exchange rate will be a particular problem for German competitiveness, and will hold back export demand this year.

The investment implications of this are to remain wary of the European economy and light in European shares, to expect the euro to strengthen , and to be heavy in Japanese shares, but to avoid the yen exposure by, for example, owning currency-hedged share classes of Japanese funds.

This was just about the minimum possible level of agreement, and the fact that it took until 1^st January to get to that point does not bode well for the chances of securing a more substantial and longer term agreement on government finances ahead of the next fiscal cliff deadline which is now 1^st March.  However, several important conclusions can be drawn from recent events:

1. All US politicians do now understand that the fiscal cliff deadline would have sent the US economy into recession if no agreement had been forthcoming, and that a failure to extend the US debt ceiling would lead to a technical default on US Treasuries with very negative consequences for markets.  Neither side wish to be seen as responsible for either of these events therefore future agreements will likely be made in time.
2. Markets believe that agreements will always be made in time and so much less inclined to panic ahead of the fiscal deadlines.  Without markets exhibiting any such fear, the politicians have less reason to give ground in the negotiations until the very last minute.
3. Obama has continued the style of his first term of not being prepared to engage directly with the Republican leaders in negotiations, preferring instead to call them to the White House in order to lecture them, and then leaving negotiations to others in his cabinet.  This is not helping to build goodwill and gather support, making substantive future agreements more difficult to achieve.
4. Neither Republicans nor Democrats are actually very concerned about the levels of public debt ($16tr, more than 100% of GDP) and the budget deficit ($1tr a year) per se.  The Republicans are essentially opposed to any tax increases, which would tend to harm their supporters, and the Democrats are essentially opposed to any spending cuts, which would tend to harm their supporters.  There is some scope for tit-for-tat concessions here, but getting beyond the minimum acceptable levels to avoid market crises will be very difficult.
5. This lack of strong commitment to deficit reduction makes it likely that there will be no meaningful austerity in the US until there are difficulties in selling the Treasury Bonds necessary to finance the deficits.  Given the weakness of the European economy following its efforts at austerity, this should support the US economy in the short term.
6. The policy of the Federal Reserve is currently one of Quantitative Easing of $1 trillion per annum until further notice.  The Fed is providing the markets with enough new money to finance the budget deficit.  Ultimately, such a policy will lead to inflation and a collapse of confidence in the dollar.

The investment implications of the above are that US financial markets continue to be supported, in the short term, by a lack of austerity and continued printing of money, but that in the longer term, these same policies will lead to inflation and a credit crisis. With this outlook, investors should broadly remain invested in company shares, wary of bonds with fixed coupons and insured with gold.

There are two distinct scenarios for 2013.  In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment.  If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively.  The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.

Investors therefore will need to seek greater protection from the risk of such a regime change.  This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations.  These assets would be index-linked bonds and gold.  The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations.  Conventional bonds would suffer very badly in an environment of higher inflation.  Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation).  However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space.  Short term prospects for returns are limited to current rental incomes alone.

In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices.  Given these two scenarios (of which the first, disappointing growth, is more likely ), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.

Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system.  Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns.  Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds.  However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds).  Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.

The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending.  This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners.  The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public.  The Italian election is also likely to see a strong performance from anti-austerity parties.  The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised.  For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.

The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target.  A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.

The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply.  The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects.  Expect a mediocre year for returns from US assets.

The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth.  Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes.  Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer.  China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate.  These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use.  Asian equity markets are once again expected to be the best-performing region of the world in 2013.

The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone.  Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.

In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great.  The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies.  These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent.  These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.

Somewhat surprisingly sterling has been the strongest of the world’s major currencies, gaining 2% against the Euro, 4% against the dollar and 13% against the yen.  With the very substantial proportion of UK stock market earnings generated overseas, this currency strength probably accounts for the slightly weaker performance of the UK market in 2012.  The best performing currency was however gold which is 7.5% higher in dollars, and 3.5% higher in sterling.

And yet, throughout the year, economic growth in Europe, Japan and China has consistently been disappointing with Europe and Japan slipping back into double-dip recessions.  Forecasts of company profits globally are about 6% lower than the levels expected at the start of the year, and European profits much worse than this.  Once again this year demonstrated that correctly forecasting economic growth or company earnings can be of little value in determining movements in asset prices.

The most significant factor in this year’s good returns is that last December there was a great deal of fear in markets that the problems in the periphery would be too much for Europe’s politicians to be able to deal with.  Stock markets thus began this year a little depressed, but rallied quickly in the first quarter after the announcement of two Long Term Repurchase Operations (“LTRO”) by Mario Draghi.  These provided about E1bn of liquidity for 3 years at 1%, which was mostly taken up by banks in the periphery, who were able to use this liquidity to buy their own governments’ bonds at much higher yields.  This generated profits for them and much-needed demand for their governments’ bonds.

After this strong first quarter, markets then gave back the gains in the second quarter as the impact of the extra LTRO liquidity faded and the global economic data started to fall short of expectations.  The Greek election (just) managed to deliver a coalition majority in favour of the bailout and austerity programme agreed with the EU and the IMF.  However the economic and fiscal situation in Spain was deteriorating rapidly over the summer, once again calling into question the survival of the euro.

In late July, Mr Draghi announced his willingness to buy up the bonds of the weaker countries in potentially unlimited amounts, and “to do whatever it takes” to ensure the survival of the euro.  This was openly opposed by the Bundesbank but once markets understood that Mrs Merkel was supporting Draghi, equity markets and the peripheral government bond markets rallied strongly to the end of the year.  Then, in September, Ben Bernanke announced a policy of monthly Quantitative Easing to be continued, initially indefinitely, or following December’s Federal Reserve meeting, until there has been sufficient recovery for the rate of unemployment to fall below 6.5%.

Since the late summer, it has been the policy actions of the ECB and the Federal Reserve that drove the markets higher, even as the economic news across Europe, the US, Japan and China continued to disappoint.

Thus the fear in financial markets, and consequent low prices, at the beginning of 2012, has given rise to the healthy returns from many investments over the year.  The transition from that fear to the more current sense of complacency, together with the poorer performance of the global economy and corporate profits, means that markets begin 2013 at more expensive levels, leaving less scope for gains next year.