FINANCIAL MARKET ?OUTLOOK 2011
The turn of the year is a good opportunity to consider the investment environment of the past twelve months and evaluate the likelihood and impacts of major changes. Looking back at 2010, economists speak of a typical post-recession year: Global growth was up almost 5% in real terms and inflation remained tame at 3.3%. In contrast, financial markets reflected a reflationary year with commodities such as gold or agriculturals up by almost 30%. The same holds true for equities, with consumer discretionaries and small caps being the 2010 winners – both up almost 25% in US dollar terms. So, are financial markets decoupling from the real economy or is the 2010 performance a harbinger of real inflation (not only asset inflation) in the years to come?
Current situation & outlook
Going into 2011, the global cyclical backdrop is becoming increasingly unsynchronised. The recovery is set to display a multi-speed pattern, with global growth driven predominantly by surging emerging economies. Asia as a region will increase its global dominance, while growth in the Americas and Europe will most probably remain below pre-crisis levels. Gross domestic product data for the third quarter of 2010 has confirmed a slowing economic growth momentum on a global scale. However, cyclical developments in China, the US and the UK have surprised, further banning the risk of falling into a double-dip recession. Leading indicators suggest that growth momentum has stagnated in the fourth quarter of 2010, but surprising and strongly improved readings in the last two months suggest an end of the cyclical slowdown or even a re-acceleration in some economies in the first half of 2011.
2 We keep our preference for cyclically exposed sector recommendations, as we expect a similar pattern in the coming months. On a regional basis, the year end has seen large variations in performance emerge. Such differences cannot be explained by sector specifics or betas alone. One of the worst performers of the quarter, for example, is the European Monetary Union, as ongoing negative sentiment owing to the sovereign debt crisis has cast a shadow over the region. Hence, an asset allocation based on a regional selection is currently more important than a pure sector-driven approach. With Asia at the forefront in terms of GDP growth, we also reiterate our positive call for the respective emerging market region. Due to its large exposure to commodities, Latin America should benefit from robust Chinese demand and deepening trade links between the two. We also prefer strategies that focus on companies with high cash balances and which are in a good position to grow their dividend payouts. The constructive medium-term outlook on equities remains intact.
Money Markets & Bonds
Global money market rates will continue to drift apart in 2011 and hence interest rate spreads between the large developed economies and emerging economies will continue to widen. Despite rising interest rates in the emerging and smaller developed economies, the overall liquidity backdrop will become even more generous in 2011 than in 2010. Unconventional or quantitative monetary policy is just one part of the explanation. A second factor is the accelerating credit creation in the emerging world as a result of hesitant policy tightening. The overall liquidity backdrop is supportive for risk appetite and therefore creates a major headwind for benchmark government bonds in 2011. Following quite impressive returns in 2010, i.e. more than 10% in 10-year US Treasuries, we project a much more challenging environment going forward. In particular German Bunds but also Swiss Confederation bonds are prone to weak performance as they are currently enjoying a kind of risk premium given the sovereign debt crisis in Europe. In contrast, the downside risks for Treasuries are slightly lower, as current yield levels for 10-year bonds are above the level justified by economic fundamentals. The same is true for government bonds in Australia, New Zealand and the Nordic countries which had priced in an excessively positive economic outlook, including further central bank tightening.
The recent strength in cyclical commodities including crude oil and copper might come as a surprise, especially when taking some of the developed world's prevailing economic woes into account. Crude oil prices recently pushed beyond USD 90 per barrel, and copper even posted a new record high at above USD 9,000 per tonne. In our view, it is short-sighted to say that the liquidity glut and quantitative easing inflate commodity prices. In fact, it is those markets with the strongest fundamentals that have posted the most gains. Inflation expectations only tend to move precious metals, but flows into physical gold products have slowed recently. In 2011, gold should remain well supported by low real rates but further upside depends on market enthusiasm and investor buying. Robust demand in emerging markets and the recovery of developed market demand continue to erode global crude oil stocks. Price spikes into the triple digits are on the table for 2011. Similarly, the scarcity of supply suggests further upside for copper prices, especially as base metals are the most exposed to the multispeed growth pattern we are expecting. Looking at current price levels, however, we believe that better entry points lie ahead, despite our constructive view on commodities.
Where are the opportunities and risks in 2011?
So where is there strength in 2011 that is worthwhile investing in? US and European consumers are saving to repair their balance sheets. Their governments have stretched their debt levels to extremes, some beyond the breaking point. In contrast, when looking at non-financial corporates we can identify the most conservative financial position since the mid-50s. Our strategists point to capital expenditure, mergers & acquisitions and distribution to shareholders as the main themes in this respect for 2011. Dividend growth, as found for example in the Dividend Aristocrats index, therefore remains one of our favourite topics. Real assets: oil and copper Liquidity will find its way into commodities as well. In fact, real assets are the "place to be" when real rates are negative. In that case, investors generate an implicit return by holding real assets as they preserve their value. In combination with a structural demand-supply imbalance, our commodity analysts favour both oil and copper. What can go wrong? Hedging the risks When talking to investors, it sometimes seems more difficult to identify what could go right going forward. Nevertheless, we have to take the major risks into account, such as policy errors (China tightening, overstimulation in the US – "a year of boom and bust"), debt and currency crises, trade wars and (over)regulation in 2011. To account for these negative scenarios in their portfolios, private investors are well advised to invest in "portfolio insurance", for instance by investing in strategies that benefit from high uncertainty.
Christian Gattiker-Ericsson, CFA, CAIA
Chief Strategist & Head of Research,
Bank Julius Baer & Co. Ltd.