The fake sound of progress
The past twelve months have witnessed extreme trading patterns. The beginning of the year saw market participants flee the equity markets to such an extent that it seemed the bottom would never be reached. However once the bottom was found in March, investors never looked back and drove stocks higher for the remainder of the year.
It has been a year of mixed fortunes. Speculators have certainly enjoyed it more than those seeking more rational, fundamentally based investments. The “bears” kept waiting for an illusive pullback, repeating the message that fundamentals do not support the recovery and as a result missed the whole upside run up in stocks. What the majority forgot was that market is not always driven by fundamentals but instead relies on individual perceptions of what is cheap, which in turn prompts herd like behaviour. The herd may have been blindly foolish, but it was the dominant theme and those that tried to beat the trend most likely suffered as a result.
In an effort to save the impaired housing market and flawed financial system the Fed devised countless liquidity measures. This cheap liquidity which has reduced the risk premia and in turn it was rewarded with a mind blowing nine month rally in equity markets which is unlikely to be repeated. The US government now headed by the messiah Obama, provided tax breaks and subsidies to consumers in order to stimulate spending. But these subsidies and gimmick programs like “cash for clunkers” simply did not address the real fundamental problems in the economy and once a program was nearing expiry the consumer sentiment would immediately falter. It became increasingly obvious that markets are now addicted to the government stimulus and like a small child, are simply unable to walk on its own two feet. But like any child, it must grow up and take responsibility for its own actions. The Fed has provided markets with all the support it needs and 2010 is the year that the markets finally begin to learn how to walk alone. Expect bruises and possible broken bones, but like they say: “what doesn’t kill you, only makes you stronger…”
Back to basics…
A likely scenario for the vast majority of asset classes next year is that the fundamental play will make a decisive come back. The majority of commentators see the reversal beginning in the second half of the next year however it is possible that markets will begin to prepare for an eventual exit much sooner. The turnaround in joblessness and a pick up in the housing market during the first quarters of 2010 will signal that a shift in monetary policy will begin in H2. However the Fed will not be in a hurry to hike and will support equity markets with zero rates for as long as possible.
USD rebound?
The rebound in the USD is likely to be driven largely by the shift towards a more normal monetary policy from the Fed. The majority see the USD remain under pressure until the Fed signals a shift away from zero rates which is only likely to be in H2. However it is possible that the USD could rebound much earlier than that given surprisingly strong GDP and a pick up in the labour market. Also the Fed is likely to stop its MBS buys in March, which is the clearest signal that QE is to come to an end. External factors such as ongoing government debt balance in Europe will aid a rebound in the USD.
UK’s D(AA)rling…
It seems that the likes of Moody’s are giving the UK the benefit of doubt on the back of a perception that debt affordability and reversibility are high. Also, uncertainty as to what party will be forced to deal with the debt means that no imminent action on sovereign rating can be taken. The latest move by the Labour government to convince markets of its intentions with a pre-budget report was met with some scepticism. Instead the pre-budget report was perceived as a pre-election masquerade rather than an attempt to persuade market participants of governments’ intentions to cut debt. In addition, the latest election polls suggest that is too close to call a winner, which raises a possibility of a hung parliament. In turn this only undermines UK’s AAA rating status since parties are so opposed in their stance on how such policy should be executed. As such, only a clear majority winner, be it Conservatives or even Labour, will determine whether the UK keeps its cherished AAA or not.
If you fail to plan, you plan to fail
There is a risk that a removal of accommodative measures will derail the recovery and send the economy back into recession. Coordinated actions by the policy makers to prevent financial meltdown are unlikely to be reversed in the same synchronized manner. The main reason being that economies across the world suffered recession of different magnitudes. The emerging economies, including China, are on a V-shaped recovery, where as the UK is still struggling to come out of recession. One size fits all policy is simply not feasible and there is a considerable risk that an erroneous monetary policy manoeuvre will cause a recovery to take an uneven path.
The central bankers will focus on the GDP and unemployment rates as the key indicators for a shift away from loose monetary policy. The GDP in the US is likely to surprise to the upside but a recovery in Europe will be much more subdued. Still, similar performance in the H2 will prove more difficult to sustain as some of the initial drivers of the recovery begin to peter out. Also, deflation fears may resurface again as economic slack weighs on prices. Despite a levelling off in unemployment in the US, a return to low levels will take several years and joblessness in Europe is seen rising for much of 2010.
House of cards…
The actions by the Fed and the US government to steer the economy away from a meltdown have been a success story of the year and officials are now in phase-2 stage, safeguarding the recovery which will eventually lead to a withdrawal from loose monetary policy. The government sponsored stimulus programs and Fed’s MBS purchases have stabilised the housing market and there are even signs that joblessness may be levelling off. The pick up in housing relied heavily on the homebuyer tax credit subsidy, which was extended as soon as the data started to show cracks when the program neared its expiration. Studies in late 2009 indicated that about 7 million properties are destined to go into foreclosure, compared with 1.27 million properties in early 2005. There is a growing fear that, once the Fed winds down its purchase of MBS in March, the housing market will see a second wave of foreclosures which could potentially undermine an economic recovery. But despite some market commentators calling for the Fed to expand the program, it looks more likely that the program will indeed expire. The next step for the Fed would be to groom the market for an eventual tightening of the monetary policy and if it feels that markets conditions warrant for such a move, it will probably start doing so in early stages of H2 2010.
Europe is faced with a problem of its own, as economic support from government incentives is also due to run out. Programs like car scrappage schemes gave an immense boost to Germany’s exports but the sales are projected to decline again next year. Also, there is a growing concern that the Eurozone has not seen the worst of the credit crunch and that many banks are still undercapitalised. In addition, the ECB’s bond buying purchase is having little impact on credit availability which contracted at an alarming rate in 2009. A similar collapse of banking system as seen in the US is unlikely, but a hostile or government led consolidation is something to look out for next year. In addition EU’s Kroes will also press on the too big to fail issue which some banks aren’t particularly too happy about.
The housing sector may be on a recovery path, albeit a very slow one, but the commercial real estate (CRE) sector is yet to see the bottom. Some policy makers tried to quell the concerns and questioned whether the CRE sector has the scope to delay the recovery. In the US, CRE will likely have a larger impact on the smaller, regional banks, which will probably lead to further consolidation, in turn exacerbating the too big to fail issue. However large cap banks in Europe will see some significant writedowns. As noted by Fitch, in Germany, CRE exposures represent a high proportion of tier 1 capital at many Landesbanks and specialist property lenders. Exposure to the most stressed markets - the US, the UK and Spain - may pose a serious challenge for individual banks' asset quality. More than 40% of German banks' CRE exposure is international, according to Fitch.
S&P…P is for Pain
The reputation of ratings agencies took a nose dive as a result of credit crunch however those same ratings agencies were back in focus in late 2009, this time for very different reasons. Public debt ratios have increased substantially across Europe in 2009 and are estimated to rise significantly further in 2010. The end of 2009 saw attention turn to debt levels in Greece, consequently actions by the likes of S&P and Moody’s only intensified fears of sovereign default. Unsustainable debt levels in countries like Greece and Ireland pose a grave threat to the recovery in the Eurozone, one reason being is that banks will not be able to borrow money from the ECB since their bonds will not meet collateral requirements. However, it is not just EU’s debt level that is in focus, UK and the US also took drastic actions to finance their stimulus and QE programs. The cherished AAA rated nations will certainly be under pressure to restore debt to credible levels or face the risk of a downgrade which will not do the recovery any good.
Stocks play…a story of two halves
Despite strong economic growth seen in the US in early 2010, the likely scenario is that stocks will underperform during early 2010, largely due to a stronger USD. As pointed out earlier, the move higher in the USD will be in part due to expected tightening stance from the policy makers but also lingering concerns over mountain of debt across the EU. The volatility across asset classes is likely to increase as investors progressively unwind their USD carry trades, however sharp fall in equities is unlikely since the policy makers will stick to their low rates stance. As such, correlation of higher USD and lower stocks will not persist for a long period. Commodity stocks and the financials will suffer most, with consumer staples/goods on the other hand will benefit from the local demand pick-up (the US), as well as the V-shaped recovery in China. The turnaround in the USD will weigh on the commodity prices and since emerging markets are highly dependent on price of natural resources, the likelihood is that investors will shift their investment focus to developed markets. Still, an era where consumers in the US are in the driving seat seems to be over and the demand will still be largely driven by China.
Commodity markets…its all about healthy correction
The pick up in energy prices, especially the run up in WTI crude which has settled into a sideways trade in the latter stages of 2009, driven largely by the cheap USD and expectation of a V-shaped recovery. Despite the pick up in prices, high inventory levels suggest that the rise was fuelled by speculators and that real demand remains low. There are numerous stories of investors across the world, especially China, stockpiling precious metals in hope of higher returns in the future. There are also oil tankers, carrying mostly distillates idle in quiet water in parts of the English Channel, Singapore and Mediterranean, which sends a false signal and distorts the supply/demand curve. Worry is then that the excess supply will catch up with fundamentals and there is a potential for a substantial correction in the near to medium term.
The rise in prices of natural resources was also in part due to portfolio diversification and as a hedge against inflation. However, despite speculation that stimulus measures and lows rates provided by the central bankers will fuel inflation, expectation and the trend remains anchored, if not inclined to the downside. The recession also prompted some investors, especially those in developing markets to reassess their reliance on the USD and even called for an implementation of a new reserve currency. In search of a protection against devaluation of fiat currencies, in particular the USD, investors turned to Gold bullion. China openly told its citizens to buy silver and Gold and admitted that it has been buying quite a bit of Gold over the past few years. India has also jumped on a bandwagon and bought a chunk of the IMF's Gold.
The closing stages of 2009 saw Gold prices retreat and according to Deutsche Bank, the correction is likely to unfold in early 2010. The large majority of economists see Gold USD 1100-1200 mark in 2010 but prices likely to climb higher should the Fed’s actions in removing the accommodative policy disappoint market participants.
