It is December, and therefore time to think about how to invest in 2011.
As an economist by training, I always like to start with a macro-economic view. My base case economic forecast is in line with market consensus, calling for moderate acceleration of the developed economies and deceleration of emerging market economies. The first stage of economic recovery driven by government stimulus and infrastructure spending will give way to more consumption and private investment-driven growth during next year. Consumers are slowly healing. Most corporations have improved their financials and are ready to expand. The job market will slowly improve, but it will take a long time to get where it was before the crisis. Inflation will stay contained and the Fed is in no hurry to stop the money-printing music, but the probability of QE3 is slim after the controversial QE2.
In the emerging markets, signs of inflation and asset bubbles are seen in some of the major countries like China, India and Brazil. Most of the central banks have already started the tightening cycles. I expect the infrastructure-driven growth will slow, but the consumption and investment-driven growth will accelerate next year.
Given the economic outlook, here is a list of my top 10 trade recommendations for 2011.
(1) Long Consumer Discretionary Sector (XLY)
After two years of bull market and household debt reduction, U.S. consumers feel better and are ready to spend. Consumer discretionary will continue to outperform even if it outperformed the market average this year.
(2) Long Technology Sector (QQQQ)
The increases in both consumer and business spending will continue benefiting the technology sector. The sector also benefits from rising global demand and a weak dollar.
Housing prices have hit a bottom and will stabilize this year. Record low interest rates and a growing economy will boost real estate demand both in residential and commercial sectors.
As global consumers become more optimistic and open their pockets, the export-led economies such as Korea, Taiwan and Singapore will perform better. The recent tension between the two Koreas has driven down the valuation (forward PE at 9.86), making Korean stocks especially attractive.
(5) Long Chinese Consumer Sector (CHIQ)
The Chinese government has adopted steps to transform its economy towards a more domestic consumption-driven economy. This process may take a while, but the consumer sector will benefit dramatically from this transformation.
(6) Buy Emerging Market Currencies (CEW)
Higher growth rate and interest rates will attract capital flows to emerging markets. The tightening monetary cycles have started in most of the emerging market economies. Emerging market currencies should appreciate against the G3 currencies.
(7) Short Japanese Yen (YCS)
The U.S. economy is improving, and will perform better than the Japanese economy next year. The huge appreciation of the yen poses potential risks to the Japanese economy. The yen will reverse its course next year as quantitative easing in the U.S. is out of the way and the U.S. economy continues growing.
(8) Buy U.S. High Yield Bond (HYG)
After two years of de-leveraging and cost-cutting, U.S. companies are in much better shape financially. The default rate is unlikely to pick up soon. The yield on HYG is currently at 7.89%. It is an attractive income-producing investment compared to the 5-year Treasury rate of 1.54%.
QE2 has made the yield curve artificially steep though the economic fundamentals are improving. The reaction to the disappointing job report last Friday was muted as the market started to adjust to the “New Normal” of an extended period of high unemployment. The Fed may realize sooner or later that quantitative easing will not solve the unemployment problem. Without the Fed’s intervention, the yield curve will start to flatten next year. Buying 30-year (TLT) against 10-year (PST) on a duration-neutral basis is likely to work out next year.
(10) Long Commodities: Buy DJP
Commodity demand continues to improve across the developed countries as economies accelerate, even moderately. In emerging markets, infrastructure demand may slow down as China is tightening, but consumer demand will pick up, supporting commodity prices.