Further Market Gains in 2010, but expect Volatility.

By Noel O'Halloran, Tuesday, 5th January 2010 | 0 comments

Further Market Gains in 2010, but expect Volatility.

 After the “Annus Horribilus” of 2008, 2009 was actually a good year, particularly for equity markets. World equities rose by almost 27% , while bonds returned 4%. It felt like a long year, as the first quarter was dominated by negative returns and fears of a second Great Depression. The remainder of the year, however, saw a strong recovery phase and a rapid move from deflation fears to reflation hopes. As much as 2009 felt long, the “lost decade” that has ended passed by very quickly, and my thoughts now turn to the outlook for 2010.
Interest Rate ‘sweet spot’ to continue
At KBCAM our base case is for a sustained but bumpy economic and market recovery. We are no longer at “extreme” cyclical points and as such we should continue to recover in an uneven manner through the new business cycle that has commenced over recent months. The “new normal” we expect over the coming few years is for the emerging market economies to continue to outperform western economies which will continue to work through the excesses of the last cycle. This sub-par growth ensures that interest rates will remain low, which provides a nice sweet spot for risk asset performance. We do expect interest rates to rise by the end of this year, but central banks have made it clear that any increases will be gradual and restrained.
Turning to markets, over the next 12-18months I forecast further double digit gains from equity markets. The 50% plus rally in equities and risk assets since the February lows was driven by cyclical and risky (highly leveraged, poorer quality) companies which performed that the best. In terms of style, I expect a significant switch from poorer quality, highly leveraged companies to companies with balance sheet strength, consistent earnings and good dividend growth. Strong balance sheets alone should put companies in a strong position to make strategic winning moves! By region, I expect the emerging markets to continue to deliver superior returns with little differentiation of return between the major western economies. I also expect that dividends will play a more important role in total return than they have in a decade, and therefore a focus on dividends will be very important.
There is the risk that central banks keep rates too low for too long and the excessive liquidity created could lead to excessive optimism in equity markets again. If this is the case it will likely manifest itself initially in emerging markets. At this point we are very far from such levels of euphoria, and so we don’t think this risk is very high.
Over the next one to three years, global central banks will begin “normalising” short term interest rates as they remove emergency liquidity measures. This combined with a challenging supply outlook in terms of funding increasing budget deficits undermines the investment case for government bonds, and I expect yields to continue to rise.
The fundamentals behind equity markets are supportive. Valuation measures show equity markets to be fairly valued, the economic cycle is just beginning,, interest rates are low and will remain low, and corporate balance sheets are strong. Corporate managers learned from the early 2000s downturn and generally maintained low debt levels this time around (unlike consumers). We should also remember that despite a 50% + rally equities are still almost as much off their highs. The UK market, for example, was more than 20% lower at the end of 2009 than it was at the end of 1999!
Events to monitor
The direction of markets I have outlined is positive, but I also expect volatility to remain at high levels as we are still coming off the bottom, with confidence still relatively brittle. At the least, I expect a period of consolidation in markets at some stage, with the risk of a more meaningful setback also a possibility. For example, events we will monitor that could drive such volatility are:
  • A premature end to emergency monetary measures, particularly the large scale buying of government bonds by the Federal Reserve and Bank of England.
  • Scares in relation to growth, inflation or interest rates
  • Emerging markets concerns, in particular China
  • Bubble concerns, should liquidity be seen to be overly abundant!
For your portfolios
The base scenario outlined clearly favours risk assets such as equities over monetary assets such as cash and government bonds and we have structured your portfolios accordingly. Within equity portfolios, style considerations favour companies and sectors with consistent earnings growth, while dividends remain very important.

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