Where should you invest in 2013?

Last year started with a crisis in Europe, followed by sluggish growth in the UK and the prospect of a daunting "fiscal cliff" in the US.

At the beginning of 2013, not much has changed. The European situation is stable but far from resolved, UK growth is lacklustre and President Obama faces a battle with the House of Representatives over tax rises and spending. Yet investors had a bumper 2012.

By and large, it was a year that rewarded the brave. Investors may not have felt like investing in a riskier area such as UK Smaller Companies in the midst of apparent economic meltdown in January, but those with the courage to do so saw an average return of nearly 20% on their investment.

Top funds of 2012

All the top funds for the year included some exposure to mid or smaller companies - Neptune UK Mid Cap, Fidelity UK Smaller Companies, Standard Life UK Equity Unconstrained.

Equally, European funds - in spite of the eurozone's ongoing problems - were the best-performing regional funds. European Smaller Companies funds recorded an average rise of more than 14%, while the Europe ex UK sector saw double-digit returns.

Surprisingly, given the slowdown in China, another strong area was Asia, and particularly Asian property.

At the other end of the reward spectrum were government bonds. Those risk-averse investors who stuck with index-linked government bonds saw their caution punished with a 2.5% drop in the value of their investment. UK gilt investors didn't do as badly, but a 2.6% rise looks pretty meagre compared with performances in other parts of the bond market, notably in the High Yield or junk bond sector, where investors saw more exciting returns.

In the end, the moves of eurozone policymakers in the form of the Long Term Refinancing Operation (LTRO) at the end of 2011 and the European Stability Mechanism formed in September 2012, proved crucial. So did the steady improvement in economic statistics seen at the end of the year, with US GDP numbers beating expectations. The turn in the Chinese economy, in particular, eased a headache for investors.


Many of the problems still remain. The US presents the most immediate issues. Mark Robinson, chief investment officer at Berry Asset Management, says: "The US election only removed the uncertainty of who was going to be in power. How policymakers will cope with reduced public spending is still to be decided. This is why markets are behaving as erratically as they are now."

Tim Cockerill, head of research at Rowan Dartington, believes that decisions made over the fiscal cliff will have a major impact globally in 2013. "If they can't come to an agreement then tax increases and spending cuts will come into force automatically on 1 January 2013 and knock around 5% off US GDP. Clearly, that won't be allowed to happen." He believes markets could bounce when it is finally resolved, but could dip in the interim on the back of the uncertainty.

Europe's problems may have been temporarily addressed but they are far from resolved. The European Central Bank may have committed to doing "whatever it takes" but real questions remain as to how much that will be.

Cockerill says: "Spain is likely to seek a bailout and Greece will continue to run out of money. At best, the eurozone will have a mild recession in 2013 led by Spain and Italy. However, a real and growing danger is social unrest because of the high levels of unemployment - currently 25% in Spain.

"The long road to economic health favoured by the politicians will be far too slow for most of the population. This year could therefore be crunch time in Europe. If so, this will cause disruption in markets."

China and the emerging markets are looking stronger and this could be the swing factor. China's latest industrial output figures showed a remarkable bounce in growth, which could reverberate across the globe, and retail sales growth is also strong and rising.

Mind the divident trap

There are a number of conclusions that can be drawn: first, that defensive assets are very expensive. Tony Yousefian, chief investment officer at OPM Fund Management, says: "Defensive areas have done very well. Anything with the slightest hint of income has risen and valuations now looked stretched."

Ian Brady, chief investment officer at Oaktree Wealth Management, highlights equity income in particular.

He says: "Equity income investing has attracted a cult-like following in the past 18 months, and while it is based on sound reasoning, we think 2013 could see certain 'dividend traps' appear.

"By that I mean companies whose valuations have simply become too expensive for the growth they are likely to deliver - where the current dividend will not provide enough support to offset the likely fall in the share price. There is also the 'dividend trap' of current high dividends not likely to be supported by moribund future cash flows, for example, in utilities and telecoms."

This means looking to the racier parts of the market. This may feel unnerving but these areas saw some momentum in the latter part of 2012. For Brady, China, Japan and European small caps could provide the punchiest returns for those willing to accept volatility.

"For Yousefian, it is China. He says: "Emerging markets have been hit because they are more export-focused. China, in particular, should be the beneficiary of a pick-up in global growth."

Gavin Haynes, managing director at Whitechurch Securities, is also backing emerging markets, and Asia in particular. He explains: "There is a high number of uncertainties but investors have to take a long-term view. Emerging markets and Asia have suffered because of the high level of risk-aversion but there is a structural shift of economic power from West to East.

"There are some markets now on very attractive valuations. There does seem to be an end to the slowdown witnessed in China, yet markets are still pricing in a very gloomy scenario."

Haynes also believes that when the market turns it could turn quickly, and those sitting on the sidelines waiting for things to get better before they invest will miss out. He points out that in June 2011, equity markets ticked up 10% in a matter of days.

Berry's Robinson also likes Asia but is adding some exposure to the US, believing US companies may be key beneficiaries of Asia's strength. Lowman at Investment Quorum shares this sentiment but is looking to specialist funds such as the Morgan Stanley Global Brands fund instead.

Rise of the unloved markets

Two other markets, much unloved in recent times, that would benefit from an uptick in global economic activity are Europe and Japan. On the surface, Japan looks horrible - its latest GDP figures show its economy contracting by 3.5% and it has an intractable demographic problem - but Darius McDermott, managing director of Chelsea Financial Services, believes it could be worth a contrarian bet.

"It was one of the weakest markets in 2012 and is looking attractive on valuations. Japan's low-growth economy and unfavourable longer-term demographics are forcing some listed companies to look overseas for more attractive sources of revenue growth. This is manifesting itself in a wide range of corporate activity.

"This is creating opportunities for those investors who understand which Japanese companies can meet the challenges of expanding their businesses overseas."

Fund selectors are increasingly dabbling in Europe, albeit through "safe" funds of, say, BlackRock's Alister Hibbert or Jupiter's Alex Darwall. A racier bet, says Stephen Peters of Charles Stanley, would be the European Investment Trust, managed by Edinburgh Partners. After a poor run of performance it is sitting on an 18% discount to net asset value, but is run by capable managers and will benefit from a higher-growth environment.

For a truly contrarian investment, Peters is looking at private equity investment trusts. He says: "The discounts are wide, the market is seeing greater activity and funds are starting to pay out dividends." He likes some of the higher-quality trusts such as HG Capital and Electra.

Low bond exposure

Fixed-income investment is a trickier conundrum. Almost no one believes there is value in government bonds and many expect weakness in the market to spill over into corporate bonds. Andrew Wilson, chief investment officer at Towry Law, says: "We have our lowest ever bond exposure. There is no cushion in the price of bonds anymore. Yields are so low that they offer no protection if interest rates rise, and the capital losses could be hideous."

Lowman agrees: "Putting money into the safest asset classes is unlikely to be profitable. Core government bonds - of the UK, Germany and US - are already giving a negative return if you adjust for inflation."

McDermott goes one step further: "Gilts will be OK until the government's quantitative easing programme ends or interest rates rise, and then there will be a dash for the exit. With average durations on gilts at nine years, even a 1% rise in the yield will result in a 9% capital loss. And if yields return to normal levels quickly, the potential capital losses are quite frightening. I still think strategic bond funds are investors' best bet because of the flexibility."

He also likes high yield and even emerging market debt. Top funds in both areas have been those from Pimco and Invesco Perpetual. Wilson also likes emerging market debt, but has moved to short-dated high-yield bond funds and flexible bond funds with the freedom to use derivatives to protect investor returns. He also likes global index-linked bonds, but admits real value is becoming harder to find in bond markets.

It will be another uncertain year and stockmarkets still face a number of headwinds, but investors should not be tempted to conclude that this means they should plump for the safest investments - in these markets, the safest investment may well bring the lowest returns.