Market Outlook| January 3, 2011

“What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from.” - T.S. Eliot

General Feel

In 2010, the winning themes included the decade old commodities and Emerging Markets as well as relatively cheaper and riskier assets. For bargain hunters, there were rewarding bets in the US from small cap growth to corporate bonds. The appreciation in value of “risky” assets is mostly caused by a bounce from highly depressed levels as a result of the 2008 crisis. Perhaps, this puts things in perspective as the majority sold while in a panic mode and then potentially created a rebirth of a new cycle. Yet, the few, daring risk-takers profited on accumulating in the spring of 2009, an era of fierce and mostly justified skepticism. These days, being a buyer of a global asset is hardly classified as a daring move, given that consensus view is not as bearish. At least, pessimism appears relatively tame, based on traditional barometers. The volatility index closed the year towards its lows, suggesting a calmer and less turbulent near-term outlook. Needless to say, this comfort is more of a reflection of the past rather than a hint into the future.

One should acknowledge that making judgment on a little over two-year period can be misleading. Therefore, it begs the following key question: Are recent gains a move towards normalization or an extended run poised for pullbacks? The suspense of answering this question is bound to play out in the day-to-day news flow, and these thoughts should float in the minds of asset managers. The heart of this curious question above is centered on interest rates and currency expectations. Importantly, key decision makers and influential participants can set the general tone. Clearly, policymakers’ recent decisions of low rates have driven corporate bond sales and stimulated additional loan issuance. For example, “Corporate bond sales worldwide topped $3 trillion for a second straight year.” (Bloomberg, December 30, 2010).

Managing Expectations

The anticipation among pundits of rising rates does not quite serve as a surprise in the financial circles. However, the market consequences and participant response is the unknown that can damage unequipped portfolios. The rate and currency speculation is bound to be highly debated and contested among buyers and sellers. At the same time, the explosive run in natural resources and further growth in Emerging Markets is most likely to correspond with currency behaviors. Simply, the synchronized price appreciation of global assets resembles the pattern of 2007. Interestingly, the last six months resemble that unified and uninterrupted movement. That said, any sudden shifts in macro trends, such as a significant rise in the US Dollar, can lead to a sensitive reaction and eventually labeled as a surprise. Therefore, this time around, unlike fearful periods of spring 2009, the opportunities might be presented for those staying patient while keenly observing. In other words, chasing rewards in this smooth sailing uptrend might prove trickier than advertised by marketplace chatter.


Article Quotes:

“The IIF calculates that in March 2008, there was about $25bn worth of pre-crisis investment grade commercial real estate in distress. By March this year, however, that number had exploded to $375bn (and has probably swelled since). Thus far, the banks have “dealt with potential delinquency problems in part by extending loans until 2011-13”, the IIF notes. Or, in layman’s terms, they have swept it under the carpet. But while this avoided defaults, the IIF reckons that about $1,400bn of CRE loans must be refinanced before 2014. Alarmingly, “nearly half of these are at present ‘underwater’, i.e. have mortgages in excess of the current value of the property” (Financial Times, December 30, 2010)

“The rest of Europe is now talking about imposing penalties on private-sector lenders in future rescues. That will turn each crisis into a game of chicken as bondholders sell before they get penalised. And financing packages do not deal with an underlying lack of competitiveness in many European economies. Without the ability to devalue, the restoration of competitiveness requires painful austerity measures and wage restraint. That leads to another potential flashpoint for 2011: the lack of global co-ordination. Gone is the consensus seen at the G20 meeting in April 2009. Europe will be pursuing austerity, China is trying to rein in bank lending but America has opted for another fiscal stimulus. This is a throwback to pre-crisis 2007, with American deficit-financed consumption set against Chinese surplus-creating exports” (The Economist, December 29, 2010)

Levels:

S&P 500 Index [1257.64] – The index finished 2010, up 12.8%. Above 1200 suggests an established uptrend. Minor pullbacks can confirm the magnitude of buyers’ conviction.

Crude [$91.38] – Since late August, the commodity has risen nearly 30%. Recently, buyers’ interest increased around $88 a barrel. Clearly, a move above a psychological $100 range creates further curiosity and contributes to ongoing herding.

Gold [$1405.50] – Since the crisis of fall 2008, the commodity has nearly doubled. This proves the momentum driven behavior which contributes to some fears for those considering selling.

DXY – US Dollar Index [79.02] – In the past few weeks, several short-lived rallies and minor declines that keep the index around a familiar and stagnant territory. Fair to say range bound, yet again.

US 10 Year Treasury Yields [3.29%] – Since late October 2008, Yields rose by nearly 100 basis points. This is a noticeable and highly watched macro trend.

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