Given that the U.S. dollar looks like it has bottomed relative to the Euro and the Yen, the S&P 500 has a good chance to outperform the MSCI EAFE index (in dollar terms) this year. Emerging markets will remain a high-octane play on the global recovery and reflation theme. If the bull market continues in 2010 and stocks finish the year higher, emerging markets will likely have another year of outperformance relative to developed markets. Conversely, if bear market conditions return, emerging markets indexes will be vulnerable to deeper corrections. Emerging markets face heightened risks from protectionism, which is a growing threat given chronic unemployment in developed countries.
Gold
Gold will consolidate for a few months before starting its next move to the upside. Gold was ripe for a pullback after a 33% rally from July to early December. Our sense is that gold will settle into a trading range for a period of time, with the upside defined by the December high at $1225 and downside risk limited to $1000 to $1050. The U.S. Dollar appears to have put in an intermediate-term bottom in early December. Pessimism towards the dollar became excessive, and debt problems in Europe reminded investors that the dollar is by no means the only troubled currency. If the Euro remains under pressure for a period of time, gold will have a hard time making much upside progress, since the two markets have had a fairly high positive correlation. However, gold is in a strong secular bull market and may well decouple from the Euro and resume its advance earlier than we expect.
Over an intermediate to longer term horizon, we continue to be bullish on gold. Driven by demand from both private investors and emerging market central banks, we expect gold to reach $1500 at a minimum over the next two to three years, and it could potentially trade much higher if speculative dynamics really take hold.
Treasuries
Treasury bonds will have another year of negative returns. 2009 was the worst year for long-term Treasury bonds in 40 years, as the yield rose from 2.69% to around 4.64%, punishing investors with a 21% loss. The only maturities of Treasury debt that didn’t lose money last year were under three years. We expect 2010 will be another disappointing year for investors in U.S. Treasuries. There will likely be periodic counter-trend rallies in longer-term Treasuries, brought about by economic growth scares and stock market downdrafts, but the major trend in U.S. Treasury bond prices is down, due to the deluge of new debt that is being issued to finance deficits, which have no end in sight.
The U.S. government ended fiscal 2009 with a deficit of $1.4 trillion, and a similar figure is expected for fiscal 2010. We think it will be hard to make money in 2010 in other areas of the bond market as well. 2009 was an extraordinary year for investors in riskier debt, because we began the year with historically cheap and compelling valuations. Then, the Fed threw a protective blanket over credit markets with quantitative easing, debt guarantees, and a commitment to a zero percent interest rate policy. As a result, riskier classes of debt had massive rallies in 2009.
However, the situation today is much different. Treasury yields are rising. The Fed is preparing to withdraw from its quantitative easing operations starting at the end of this quarter, and may soon signal a move away from zero percent interest rates. Credit spreads (relative to Treasuries) have fallen back to levels seen during healthy economic times, offering little margin of safety. Investors face near-zero returns on money markets, but that is preferable to losing money, which is a very real possibility in many areas of the bond market.
Housing
Housing remains a key risk in 2010. Fragile conditions in the housing market remain a key risk for the economy, the banking system, and the stock market in 2010. Sales activity has been stronger in recent months, and prices have firmed in most parts of the country, but recent positive trends in housing may turn out to be a temporary reprieve, created by government home purchase incentives and the spike down in mortgage rates that occurred last fall.
A number of risks loom for the housing market in 2010, and the possibility of another significant (e.g. 5% to 10%) drop in prices should not be discounted. In the past month, 30-year mortgage rates have jumped nearly a half percent. This move up in rates is already putting pressure on housing activity, as reflected in recent mortgage application data, and will also have a negative effect on home prices. Mortgage rates are likely to continue to rise in 2010, given the downward trend in Treasury bonds and the Fed’s intention to wind down its direct purchases of mortgage backed securities, which totaled over $1 trillion last year.
In addition to the risk of higher mortgage rates, the home price outlook remains clouded by an overhang of existing home inventory, which may get worse in 2010 as a result of foreclosures. Approximately 14% of homeowners are currently delinquent on their mortgages or in foreclosure. This is the highest level ever recorded by the Mortgage Bankers Association. Moreover, high levels of mortgage defaults and foreclosures may continue in 2010 as a result of (1) 15 million mortgages (23% of U.S. home loans) being in a negative equity position; and (2) another wave of adjustable-rate mortgage resets. It is a fair assumption that a large percentage of the loans that will reset this year are “under water,” because they were taken out towards the tail end of the housing bubble, when prices were most inflated.
There is a high correlation between “under water” mortgages and default rates because borrowers have less incentive to make their payments if they are in a negative equity position. Interest rate resets threaten to aggravate the problem of defaults and foreclosures if the amount of the mortgage payment is increased, which is typically the case in a reset scenario. Renewed weakness in home prices in 2010 would be a significant negative for the financial markets, because it would create new problems for the financial sector, and place addition stress on household balance sheets, which would in turn depress consumer confidence and spending.
