We are cautiously positive for the global economy, and for global equities in particular, as we look ahead into 2013. Global economic conditions remain challenging, and markets are still pricing in a substantial degree of bad news even after the gains made in 2012.

However, some macro improvements—the bottoming of Chinese growth, continued recovery in the United States and the beginning of the healing process in Europe—and a global environment of high liquidity will be strongly supportive for markets over the next 12 months.

Japan’s Radical Action

We talked last month about the incoming government in Japan. New Prime Minister Shinzo Abe has come to power on a strong mandate of radical central bank action and increased spending on public works in order to pull the country’s economy out of recession and end crippling deflation. Already, the Bank of Japan has increased its asset purchasing program by another $118 billion and has adopted a 2% inflation target.

Unlike in Japan, where the government’s intentions have been made clear, U.S. monetary policy has been more scrutinized. The Federal Reserve’s successive rounds of quantitative easing provided welcome support for equity markets in 2012. In December, the Federal Reserve announced that it intends to almost double its quantitative easing to $85 billion a month and said that it would continue QE until there was a “substantial improvement” in the labor market. Linking quantitative easing to employment targets in many ways makes official a policy that was already in place.

U.S. Policy Remains Expansive

This was understandably welcomed by markets, but the United States’ commitment to quantitative easing was called into question by some when the Jan. 3 FOMC meeting minutes highlighted a dispersion of opinions about how long asset purchases will be appropriate. The senior leadership at the Federal Reserve appears to remain committed to more QE for the foreseeable future. While it is possible that the Fed could bring an early end to its QE program—perhaps toward the end of the year at the earliest—we think this is a low probability outcome, and one that would only be realized if economic growth gathers momentum. As such, we expect any reduction in quantitative easing would be gradual and matched to economic conditions.

The Federal Reserve is sensitive to the role QE plays in market confidence and would undoubtedly avoid undermining confidence. An early end to QE due to strong economic conditions and a substantial improvement in the labor market would be an encouraging sign for equity markets, as it would suggest the Fed believes the U.S. recovery has enough momentum to sustain itself.

Global Conditions Support Risk Appetite

Meanwhile, in China, we do not anticipate a stimulus project on a level with its 2009 stimulus. Like many other emerging market economies, it is at the end of its tightening cycle, and we can expect selective measures in support of its economy over the next year. With Japan and the United States continuing with asset purchasing, and the European Central Bank under Mario Draghi’s leadership highly supportive, a global environment of high liquidity will support global equities in 2013.

This liquidity has already boosted the “risk-on trade” and should be expected to drive a further re-rating of risk assets and cyclically exposed stocks in the near term, so long as macro news flow remains benign. While we do expect some continued volatility in equity markets due to issues such as residual fiscal cliff problems in the United States and elections in Italy and Germany, we see equities as being attractively valued with good opportunities for patient investors to expand their equity holdings.

As we continue down the rocky path to normalization, equities continue to be extremely cheap compared to bonds as witnessed by the equity risk premium. We therefore expect the high levels of global liquidity to give confidence to investors to act upon the disparity in valuations between fixed income and equities.