05 January 2010

What’s in it for 2010?

Where were we in 2009?

After a disastrous 2008 that witnessed a global financial and economic meltdown not seen since the 1929 crisis, the trough was finally reached on 9 March 2010 in the West (China bottomed out late 2008) with an additional 35% decline in the US stock market from 1 January when the market finally realized that Armageddon will not concretized with central banks all around the world reflating the economic activity to unprecedented levels in history.

Fiscal policies added to the glut of liquidities created by central banks that found their way into risky assets, since deposit returned next to zero. Unsurprisingly, emerging markets stubbornly outperformed developed ones, reflecting higher economic growth, less affected financial systems and much higher saving rates.

Whilst inflation fell, deflation did not spread.

Yield curves steepened and spreads narrowed significantly, many back to pre-crisis levels (particularly TED and OIS indicating a return to normal conditions in the inter-banking market). Volatility in equity markets decreased as the year passed, with financial and information technology stocks the outright performers together with low-quality securities that were on fire-sale during the nadir of the financial crisis.

Where are we today?
The unprecedented Government stimulus induced an economic growth from Q2 2009 but did not mend the structural problems:

1. Banks’ balance sheets are still weak and they are not lending to the real economy. The private sector has not taken over the public spending.
2. Unemployment is high and should move higher during Q1 and probably Q2 2010; even if growth increases as many suggest, unemployment will remain high.
3. Commercial real estate and credit cards delinquencies are still increasing; residential real estate is still very weak and look to be at a standstill in the US (the refinancing of many a couple of hundreds of billion dollars in 2010 will have to be closely monitored); all measures taken have postponed the purge, not solved the problem.
4. The huge deficits and additional debts accumulated by western countries will not be able to re-engineer a second stimulus package if the private sector remains idle. The reduction of public debt and budget deficits will need to be addressed.
5. Over the past years consumption and therefore economic growth, particularly in the US, was build on over-indebtedness: the deleveraging has not ended yet and what model, if any, will replace it?

So, what are my 2010 predictions?

1. Western economies will have a positive growth, below average (currently 2.2% vs 7.3% during a recovery phase), and will significantly underperform developing economies.
2. Job growth will start to show up in H2 2010, but moderately and well below what we were used to during a recovery phase.
3. Inflation will not yet be a major worry.
4. Gold and precious metals after a consolidating period will forge ahead but will not run away until inflation becomes a real worry and / or there are political troubles in sensitive countries/regions (mainly the Middle East and Afghanistan/Pakistan/India).
5. Interest rates will rise, making fixed interest rate securities a bad investment. Buyer of Western debt will need and want a higher return for a higher risk since I do not expect Western Government seriously tackling the deficit and debt problem hoping growth will do the job.
6. Selective equities will outperform cash and fixed income securities.
7. Energy, commodities (including agriculture), information technology and healthcare will outperform. Retail will also outperform if consumers go back shopping (which I dot expect in significant terms).
8. M&A activity will jump.
9. China will continue to assert its emerging superpower status and conflicts with the US will be more numerous and acute (the question is who has the most annoyance power – my guess is China at this juncture; just see the Copenhagen summit on the environment). This will be particularly true in securing access to commodities and energy sources.

To conclude, I expect the start of 2010 to be fine, then to deteriorate quite rapidly (2-3 month) with a correction of 20-25% in equity markets and then partially recover in H2 2010 if there is no economic policy mistake or no unexpected external shock. Right now, and according to David Rosenberg from Gluskin Sheff, the current S&P 500 level discounts a 5% growth for 2010, which is way over the top. In any case, I do not expect a great year for equities as a whole: if the economy improves, markets will fear interest rate tightening and otherwise will discount a worsening situation. I would be short financials and long technology, commodities/energy and pharmaceuticals.