The year 2009 has again shown investors that the signals we get from financial markets and those we get from macroeconomic factors can sometimes be very far apart in the story they tell. This year has also illustrated how crucial it is to always look at the present in order to get guidance for the future. The past year has been extraordinary in many ways. Especially noteworthy has been the magnitude of the economic contraction, with GDP falling between 2%-5% in major economies, a situation the likes of which has not been faced in recent history.
Comparing this slowdown and market crisis to previous corrections or market collapses might help to explain some of the aspects of this crisis, but, we think looking at past events alone to predict the future is often too simplistic since every situation is largely unique. Many prognosticators today predict that we are just experiencing a temporary recovery and that the “mother of all crises” will soon be upon us. We shun this view for several reasons but do agree that the magnitude and implications of the present crisis are likely bigger than those of most any comparable historical event.
It’s very easy to get confused by today’s market environment and hearing many prominent “doom-sayers” claiming that the end is near. It’s even worse because we are now faced with a changing world order with far reaching implications for decades to come. We are an independent investment manager and therefore try to use independent thinking when we analyze markets and make investments.
The basic story hasn’t changed; the global economy is going through a period of rapid change and the centre of the world, both economically and strategically, is shifting to the East, mainly Asia. We are moving toward a multi-polar world order, much different to the bi-polar world we have been living in at the end of the last century.
We expect that world GDP growth will accelerate to about 4% in 2010 and that more than 70% of that growth will come from new markets such as China, India and Brazil. Capital will flow to markets that experience a stronger economic growth pace; this is a basic law of finance and is proven by the growing capital flows to these markets. These capital inflows have helped push up equity prices in those economies by 50%-100% in the last couple of months and many investors now believe that these markets are overvalued. We strongly disagree, but do admit that these markets might look expensive when compared to western markets.
However, investors need to realize that we are dealing with a strong and very powerful paradigm shift here which could result in chronically high demand for investment in these regions for many years to come. We think investors will talk a lot about the emerging market bubble in the years to come and yes, there will be corrections along the way, but we feel that these would be good buying opportunities.
Don’t get us wrong, we are not of the opinion that everything is perfect in emerging markets, we do see things we don’t like and have some concerns as well, but, economics is seldom about things being perfect. As global growth recovers toward a more normal rate, we do believe that western economies will recover. There are, however, going to be significant differences in countries’ relative performance during this economic rebound. We are most concerned about the United States as well as some European nations. On the other hand we are very upbeat on countries such as Australia, Norway and Switzerland for various reasons.
Also, accelerating global growth will help to drive up corporate profitability and we believe that the earnings over the next couple of quarters could surprise to the upside since corporations have generally a very high degree of operating leverage and therefore increased sales will translate into even higher profits.
Many investors have missed the market rally this year and are still on the sidelines, waiting to enter the market when markets consolidate. This seems to be one of the reasons why markets seem so well supported against the downside at the moment. When did we have the last significant 3%+ move to the downside? It’s been a while. And, when stories like investor darling Dubai running out of money don’t even cause a market sell-off, the market is probably not too badly protected on the downside.
With the global economy in recovery mode, ample cash sitting on the sidelines and corporate profitability on the rise, we believe there is a good chance to see further upward momentum in equity markets next year. Of course, our scenario is based on the assumption that we do not get any surprise shocks next year – internal or external to financial markets. What could be a possible shock in the future? A terrorist attack a pandemic flu or another geopolitical event? It could be any of the above. But with markets being quite resilient, we think even in such an event the consequences should be predictable and manageable.
After all the difficulty of the last two years, markets and investors have become quite adept at handling all different sorts of crises. We are more concerned with the health of some nations given the burden of being some of the biggest debtors in the world. We think that the next big theme will be in credit markets with investors getting increasingly concerned about the health of states and countries. For a long time, government debt was considered a risk-free asset, since the common view was that established countries don’t go bankrupt because they can always raise taxes and/or print money to pay for it. In a globalized world this is not the case and it’s actually a very unrealistic assumption.
Raising taxes makes a domestic economy less competitive and will result in companies moving to other countries and excess money printing will destroy the wealth of a nation and the value of its currency. Neither option is a valid sustainable one, which means that the correction needs to be made eventually via spending cuts. As an example, the current US debate over more government spending on healthcare and other items goes in the wrong direction since government services (e.g. expenses) need to be cut dramatically in the long-run in order to manage debt. At the same time demographic shifts in western nations will lead to an explosion of costs for healthcare and social security. We believe that more and more countries will struggle with these adjustments and we think that the present debt situation with Greece is just the beginning.
Another change we are watching for in 2010 is a relatively strong upward pressure on energy and commodity prices. A normalization of global growth in combination with the unique supply and demand curves for energy and commodities will result in an exponential price increase. Gold and other precious metals are a special case and are driven by other factors. The concern about the global financial system and the generation of ample (and probably excess) liquidity by central banks around the world has increased concerns about paper money as a store of value. These concerns are valid in our view and we don’t think gold is overvalued at current prices considering all the factors previously explained. We can see gold prices taking a breather here for a couple of months with the most likely scenario being trading within some range. Eventually, rising inflationary pressures, which we can see emerging in about 2-3 years, could eventually help in driving the price of gold to USD 2’000.
“Outlook and Forecasts for 2010”
Taking all of these factors into consideration, we expect the following in the coming year:
Global growth to normalize at around 4% GDP, mainly driven by growth in emerging markets
Equity markets to rise another 10%-20% in coming months due to increased corporate profitability and operating leverage
Re-pricing of risk in bond markets, especially sovereign debt
Short-term rates to remain low for another few months but to rise strongly later in the year
Long-term rates to move higher, but more moderate than short-term rates
Inflation to remain at very low levels for another 12-18 months
Energy prices to move higher with oil breaking USD 100/barrel in the first half of 2010
Soft commodities to move sharply higher with upside potential of 30%+ in 2010
Gold to consolidate after strong upward move, trading in narrow range in Q1/2010
Gold to continue upward trend in second half of 2010
U.S. Dollar to move lower, despite temporary upward bounces
Disclosure: "No positions"