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Previously I have held back from providing any traceable documentation of crystal ball gazing for the coming year, but this year, partly as a challenge to myself, I have succumbed to the temptation and below offer a collection of my very broad prognostications for 2010.


Within the larger time-frame context, I am still of the view that the world economy faces a risk of continuing deflation as the structural bear market dynamics, which took hold in 2000 alleviated periodically with bubble blowing exercises designed especially to re-inflate US asset prices, are still extant and may well haunt the global capital markets for several more years.

Having said that, the extraordinary initiatives of central banks and policy makers, throughout late 2008 and all of 2009, to bailout any business that has been deemed to be strategically important or too inter-connected to fail, has created a highly unusual financial backdrop which has supported a new kind of risk taking during the last three quarters of 2009.

Adventurous asset managers and proprietary trading desks have been enticed back in to equity and commodity markets, to provide the liquidity lifeblood which modern financial engineering requires, by a not so subtly hidden safety net which takes the form of an accident protection package which is completely underwritten by the full faith and credit of the taxpayers of most of the world’s economies.

US Equities

I see the S&P 500 hitting both 1280 and 870 during 2010, and it seems more likely that the 1280 comes in the first half and the 870 comes during the summer months or second half of the year. Both are key technical levels, as seen on the chart below, and the timing will have to do with the market's perception of when the Fed is planning to exit its super-accommodating monetary policy. I am sure there will be some significant missteps regarding the exact timing and mechanics of the exit strategy, and traders as well as the Fed itself could easily become confused by the economic data and the underlying strength of the banking system.

However, at some point during 2010, unless there is another systemic crisis, the Fed will have to begin raising short term rates and draining liquidity from the financial system to maintain any semblance of credibility. At the first real evidence that the die is cast in favor of higher rates, the market, which prides itself on its ability to discount all known information, will suddenly realize that it has not fully discounted the actuality of higher rates and will, almost certainly, panic. There could easily be a series of nasty sell-offs and that is why I anticipate a re-testing of the July 2009 lows around 870. Should this level fail, which I tend to think will not happen, then an S&P 500 level with a seven as the first digit becomes a real possibility.


Since I believe that the US stock market will essentially gyrate within the range just outlined, in an almost bi-polar fashion during 2010, I do not have firm view on where we shall end the year but my hunch is that it may not be too far from where we end this year.

US Treasuries

There are mounting technical and fundamental reasons to believe that the 20 year bull market in long term Treasuries is over. In my estimation there will be gradual yield creep in longer term Treasuries which should take the 10 year up to, and quite possibly beyond, 5% during 2010.

The quarterly chart above shows the decline in yields for the 30 year Treasury bond over the last 20 years and, as can be seen, the drop below the descending wedge formation seen at the end of 2008 has more or less been corrected as yields have almost doubled during the last 12 months. The current level of 4.7% represents a critical level, which when broken to the upside, could well be a game changing event for the financial economy.

I expect the yield on the 30 year Treasury to get to 5% in coming weeks and a six percent coupon is quite conceivable during 2010 for this maturity if, as announced, the US Treasury continues its attempts to push out the duration of its new issuance.

According to one source 40% of all Treasury debt matures within a year - which is extraordinarily problematic in itself - and Treasury Secretary Geithner is on record as saying that the Treasury will be managing its issuance in coming years with a view to selling more long term securities... it clearly has to, so as to avoid the classic mismatch between the long term US government obligations and a very short term funding horizon.

According to Morgan Stanley estimates, the Treasury will have to sell a record $2.55 trillion of notes and bonds in 2010, an increase of about $700 billion, or 38 percent, from this year.

If anything the yield curve could get steeper - and will be influenced as much by growing risk aversion of the long end of the yield curve as by any upward trend in short and medium term rates.

Emerging Markets

Amongst the many persuasive purveyors of positive arguments for global asset manager with a long bias there is an enormous amount of "hope" being rested in the BRICs and other emerging markets, much of it coming from Jim O'Neill at Goldman Sachs (NYSE:GS) and also analysts at other large Wall Street and Canary Wharf based firms. Based on the recent attainment of key levels and other technical divergences, stock markets in Brazil, India and Hong Kong could well be vulnerable to setbacks, and it may well be that the real opportunities lie in some slightly less visible markets such as Chile, Peru, Egypt, Morocco and Turkey as well as other geographical regions outlined in this thoughtful piece.

In addition, as at other times in modern economic history involving new frontier financing, there exists the possibility of a major mishap - either inflationary pressures (as for example in India and China), financial mismanagement or scandals and accounting shenanigans in certain much hyped regions, and the possibility of capital flight in the case of a currency crisis for (say) the Russian ruble or the Indian rupee.

Commodities

This is the area that I am most tentative about and for which I have decided to keep my head well below the parapet.

In general terms, the level of overall commodity indices would, I expect, be very dependent on the strength of the US currency and the continuation of the FX carry trade. The key will be to watch the Australian and Canadian dollars - they will be the canary in the coal mine warning on any seismic shifts in the tactical "warehousing" of industrial commodities by large funds and proprietary trading desks.

In addition, the activities of the Chinese government in continuing to diversify away from its over-reliance on the US dollar and dollar denominated paper assets will be a major factor that will be supportive of industrial commodities. So overall I would suspect that metals, the energy sector and resource based economies (e.g. Canada) will continue to be outperformers in 2010.

Foreign Exchange

The euro will, I suspect, most likely remain under pressure for most of 2010 as the Eurozone economies drift further apart in terms of economic performance. It is even possible that one or more of the current EZ members (Greece, Italy, Spain, Ireland) could exit the EMU. It would not be surprising to see the euro back below $1.30.


The weekly graph of the EUR/USD shows a rather ominous technical pattern which indicates how the Eurozone currency has dropped decisively out of a rising wedge pattern and is in the midst of breaking another key uptrend line.

Sterling could also drop down to the $1.30s (implying parity for EUR/GBP) and if the UK election (due before June) proves indecisive with a split Parliament one should not rule out a UK gilt buyers' strike and currency crisis. This would present the Bank of England with a really hard choice between defending the currency with higher short term rates or re-scheduling further quantitative easing [QE] which could be yet another blow to the credibility of the UK government’s fiscal rectitude.

Overall, the outlook for the UK economy is not at all appealing but the UK’s FTSE index may still outperform on a relative basis, partly as a result of its exposure to the commodities sector, and partly as a reflection of the fact that sterling has already dropped by more than 25% against the dollar during 2008/9. The FTSE is one of the few major mature economy indices to be close to challenging the 62% retracement level of the major swing moves of the last two years.


The hardest currency pair for which to make a prediction is USD/JPY. Many pundits are of the view that the US dollar will strengthen across the board during 2010 but the yen is always the exception that could prove the rule. If yields on US Treasuries continue higher, as I believe that they will, then that would suggest that the Nikkei 225 will have an upward bias during 2010 (there is a long standing and somewhat enigmatic correlation between yields on long dated US Treasuries and the level of the Nikkei as revealed in their relative performance over the last 20 years shown in the graphic below) and, in turn, that would suggest that there will be a trend towards yen weakness.


If I am wrong about Treasury yields, which could result from a major miscalculation by the Fed which derails the US stock market, (some cynics might even suggest that creating a correction in equities could be more of a deliberate tactic by the Fed to prop up the Treasury market) and yields don't rise the way I think, this would suggest that the yen, as part of a renewed global flight to safety, would strengthen against the US dollar. Needless to say that would not portend well for the Nikkei, US equities, emerging markets, high yield debt, and for risk assets in general.

The fact that for both scenarios, compelling cases can be made, underlines the risk of making the kinds of predictions that I am, and also highlights just how much the well-being of the US Treasury market represents a critical and potentially singular point of failure for the entire financial system.

Japanese Equities

The weekly chart for the Nikkei 225 shows that a move up towards the 12,000 level appears more probable from a technical perspective since the Japanese government mounted a serious rescue remedy for the index when it threatened to break below 9000 in late November 2009. That latter level would now seem to represent a line in the sand for traders as a drop below that would be extremely negative for this market.


Gold

I forecast in my daily newsletter in early October that spot gold was on the verge of breaking above the neckline of an inverted head and shoulders pattern and that upward price projections based just on the pattern alone would suggest an intermediate target price of around $1320. This can be illustrated in the weekly chart for gold which is seen below (click to enlarge).


The $1320/50 zone remains my six month target, although a drop back towards the $1000 level is quite possible before then. Longer term, and perhaps within the latter part of 2010, $1600 per ounce could well be seen as China, India, Russia, Brazil and even parts of the Middle East will continue to diversify their reserves away from over-reliance on the US dollar as a store of value.

Real Estate

It is hard to see really constructive dynamics to help the residential property markets in the US, UK, Spain, Ireland, Greece, Italy etc. There are well documented and massive foreclosure and over-supply issues in the US and an estimate that more than 25% of all homeowners are facing negative equity. The situation in the UK may not be so drastic, on the surface, but there are reasons to believe that potential supply would overwhelm demand on any signs of a property rebound or if, as is likely, adjustable rate mortgages were to start moving higher as the Bank of England hikes rates, perhaps aggressively so, in defense of sterling as previously discussed.

Woes in commercial real estate will become increasingly problematic not just in the US but, echoing Dubai, increasingly in the emerging world - India and China are also developing a glut of commercial property and there is growing reason, as with Dubai, to dis-believe in the notion of “build it and they will come” even in those economies, which ostensibly are growing rapidly. Just as in the mature economies there has been a profligate use of easy financing to misallocate resources and create an overabundance and excess capacity of business infrastructure. In general there is a danger that the emerging market infrastructure story, just as with the arguments which lead to a massive over-supply of freight shipping capacity, has already played itself out in the intermediate term.


Summary

The great juggling act for the central bankers of the “mature economies” during the latter part of 2010 will be their expressed desire and need for much stronger GDP growth for 2011 and beyond (indefinitely no less!) of at least 3% plus per annum, but still with a benign enough inflation outlook to retain relatively easy monetary policy.

The risk of continuing too long with virtually zero interest rates and a more vibrant private financial services sector which will help to prop up asset prices is that it runs a substantial risk of creating greater political unrest between those who are reaping the benefits of financial wizardry and the average Joe who is likely to remain under-employed at best. This could spill over into more disaffection with political leadership, more skepticism on the part of surplus nations that they should continue to feed the deficit nations' debt addiction problem and, in turn, this would raise the risk, not just of the few remaining AAA credits being downgraded, but the real possibility of sovereign defaults.

Depending on just which sovereign[s] might default, that would be the "outlier" event that could consign this whole exercise in soothsaying into the delete bin, and require a newer and even bigger bailout of the financial system. Let's hope we don't have to test the viability of that option!
Source: What Lies Ahead in 2010?