2013: Lower returns and macro and portfolio transition. After years of a downward macro risk skew, we see the current risk profile as more symmetric. Markets are likely to stay volatile, with several tradable moves up and down, influenced by politics and the ongoing pressure to de-lever. But as the year progresses, we see a positive macro tilt forming into 2014. Consequently, the risk/reward across fixed income and equity is also transitioning, albeit slowly.

Equity allocation higher; fixed income, specifically credit, lower. Even with financial repression, the room for error is slight for bonds. We have slashed our US credit overweight. As an example, our baseline return for the higher-beta fixed income market of US HY bonds is a paltry 3.1%. On the equity side, we continue to prefer EM and Europe over the US.

We will remain in a low-return world. Investors are improperly extrapolating the total returns of 2012 into 2013. Given that returns were largely valuation gains, it is important to remember the catalyst of policy-makers’ removal of tail risk, a benefit that occurs only once. Furthermore, assets are more expensive than a year ago – global equities are on a PE of 11.8 now compared to 10.3 a year ago. This will constrain returns.

Top 10 trades of 2013: Overweight AXJ and Europe versus underweight US equities; China cyclical risk in US and Europe stocks; long Italian and Spanish sovereign bonds; long Bunds versus UST and JGBs; long European credit versus US credit; take structured risk over duration risk; buy $/yen; and long gold.