Andreas Utermann, global chief investment officer at RCM, looks ahead to another exciting year for capital markets.
As we head into 2011, I will focus on the themes likely to shape the direction of capital markets and provide a brief outlook for each major asset class. In doing so, I shall highlight our predictions from last year and contrast this with how actual events played out.
Currencies
Our prediction for 2010: We expect the US dollar to be structurally weaker against the Asian currencies in particular, but also against the euro to a lesser extent. In the short term we believe the US dollar to be oversold and expect a bounce, but in the latter part of 2010 global currencies should have re-embarked on the secular path.
Our prediction turned out to be very prescient indeed. The US dollar appears somewhat oversold and could rally against the euro. Longer term, we continue to expect emerging market currencies to appreciate in nominal and real terms, mostly against the US dollar and somewhat less against the euro. The yen continues to confound expectations of a long overdue crash by appreciating significantly on a trade-weighted basis.
Equities
Our prediction for 2010: Equities could continue to rally over the coming months, supported by strongly rising earnings momentum, but as the sustained return to trend growth fails to materialise for many OECD economies, markets could well suffer a setback in the middle of 2010. Longer term, having just seen the worst decade on record in real terms, equities may once again offer value. Dividends and currencies should feature more prominently in investors' minds.
The markets have played out exactly as predicted. As we head into the New Year, they are finally trading above their pre-Lehman levels, driven by positive earnings surprises, the continued growth of emerging markets and quantitative easing (mark 2). Albeit, this is still significantly lower than previous peaks, in nominal and especially in real terms.
Quantitative easing (mark 2) will provide a continuous boost over the coming months, but we are likely to see a return to risk aversion, perhaps triggered by political and trade tensions or sovereign debt fears. This would, in our view, be another buying opportunity for those who have missed some of the recovery and want to establish longer-term positions. Alas, we are unlikely to see the previous lows. With interest rates in the OECD continuing to provide no protection for future inflation, and property either depressed or, as are commodities, in potential bubble territory, equities would appear the only game in town. I favour quality franchises with a dividend yield, companies with exposure to emerging market growth, while continuing to be cautious on financials. Note that these preferences could reverse following a bout of risk aversion, during which emerging market equities would probably underperform.
Interest rates and bonds
Our prediction for 2010: We expect short-term interest rates for the major economies to stay accommodative for most of 2010.
For 2011, we anticipate little movement in short-term interest rates for the major OECD economies, but gradual tightening in the emerging markets. We would be very cautious towards medium to long-term maturities across the world, which we feel are significantly overvalued owing to quantitative easing activity and undue risk aversion.
Inflation
Our prediction for 2010: Inflation will not cause a problem in the foreseeable future as the current disinflationary forces are still powerful, but inflation will embark on a secular uptrend from 2011 onward.
Our prediction has so far proved correct. Significant output gaps persist in the UK, Japan and the US, as well as most eurozone economies. With growth continuing at a below-par rate, these gaps are not being absorbed rapidly, deflation being the more significant threat in the US. Given the still precarious state of the financial system, high personal debt levels and the still over-extended property markets in the US, the UK, Spain and Ireland, the monetary stimulus has not yet led to higher lending. Consequently, as anticipated, the Federal Reserve Bank has adopted an inflation target in an attempt to anchor inflationary expectations at a higher level.
On the other hand, emerging markets have maintained their trend or slightly above trend GDP growth rates, which, coupled with continued loose monetary policy globally, has put upward pressure on inflation rates there and in resource-rich economies such as Australia. Monetary tightening is expected to continue throughout 2011.
Therefore, 2011 will see diverging inflation trends, with continued moderate inflation within the central banks' comfort zone in the more highly indebted countries and higher inflation in the countries with on-trend or above-trend growth.
Budget deficits
Our prediction for 2010: We project budget deficits globally to expand significantly through 2010 and possibly 2011. For many OECD economies this may lead to rating downgrades, but we believe the threat to the solvency of major economies to be limited.
Sovereign debt has come to the forefront of the market's concerns this year and financial institutions remain under pressure. We have seen markedly different responses across the world to budgetary pressures. The European nations, the UK included, have embarked on a course of austerity, with a mixture of expenditure cuts and tax increases, hoping to gain credibility in financial markets to keep long-term funding costs down and encourage investment in the medium term. Remarkably, it is possible that for some countries, Germany and Sweden for example, there may be room for tax cuts beyond 2011. The US is alone among the major economies to continue to expand fiscally, albeit against the background of an increasingly fierce 'tea party' backlash. This, coupled with unprecedented quantitative easing (mark 2), is clearly unsustainable and could, if unchecked, lead to a crisis in confidence in the US dollar.
While major sovereign defaults have been averted, the spectre of debt restructuring or even default for some of the eurozone's peripheral countries will continue to haunt the markets. Unless steps are taken in the US to fix
the budget in the medium term (which will be difficult given the split congress), concerns over US credit worthiness will mount in 2011.
Future bubble formation and central bank policy
Our prediction for 2010: We believe the risk of future, systemic bubbles that have the potential to derail the global economy, or large parts of it, to be effectively over. The 'Greenspan Put' has had its day. It is possible that the current accommodative liquidity conditions will not be easily sterilised - leading to a mega bubble in equity prices or indeed to runaway inflation. At this point we regard this as an outside possibility only.
Worryingly, central bank policies have diverged significantly this year and have not played out quite as anticipated. Quantitative easing can only be justified to address significant distortions to the cost of capital that result from credit markets not functioning properly. In terms of rhetoric and actions, the European Central Bank has acted to reduce quantitative easing, despite the difficulties in the eurozone's periphery. Benchmark yields have not been affected by its policies and were not meant to be. The Federal Reserve Bank, on the other hand, has embarked on a further round of quantitative easing with the aim of raising asset prices, considering that the risk of further bubbles or violent swings in exchange rates is worth taking to avoid prolonged below-par growth. Leaving aside my doubts about whether monetary policy can affect growth positively, I am concerned that this course of action will distort the cost of capital, leading to sub-optimal investment decisions by economic agents and significant geopolitical frictions.
Thus, for 2011, we need to look out for signs of bubble creation, for example in commodities, emerging market property or long-term OECD debt, and brace ourselves for enduring volatile capital market conditions.
Emerging markets
Our prediction for 2010: The macroeconomic and political significance of emerging market economies has changed for good as a result of the crisis, with them playing an increasing role in the global political and financial construct.
With Brazil, China and India continuing to grow strongly and preventing the OECD economies from experiencing a double-dip scenario, as well as providing important direct (through purchases of sovereign debt, including that of weaker economies such as Greece) and indirect (through stronger trade ties and slowly depreciating currencies) financial support, the strategic importance of emerging markets has been confirmed. 2011 will see a continuation of this theme - goodbye G7 and hello G20.
