In the end, 2010 was a positive year for investors as most fixed income and equity indices ended the year in positive territory. Our expectation of a positive but volatile year for equities proved well founded as the asset class ultimately delivered healthy returns as the global economic recovery stayed on track, led by emerging market growth.
It was not all plain sailing, however, as markets were buffeted by periods of weakness triggered by concerns about high government debt levels, particularly in Europe, and by fragile global investor sentiment as we continue to recover psychologically as well as economically from the blight of 2008. Moreover, government bonds were much stronger than many investors anticipated, delivering an attractive positive return as central banks’ exit strategies from accommodative monetary policies were deferred into 2011 or even 2012.
Our attention now turns to 2011. Many commentators are relentlessly positive on the outlook for riskier assets such as equities and commodities. We are perhaps more considered as the level of uncertainty created by overhanging issues such as European sovereign debt levels and rising emerging market inflation (probably more a 2012 problem in reality) is much higher than at comparable stages of past economic cycles. At the very least, they should engender ongoing volatility. But despite the sharp price movements in the final months of 2010, with strength from equities and notable weakness from government bonds likely to reduce the return differential between the two over 2011, starting valuations still suggest that equities should be the asset class of choice over the year as long as investors can stomach savage short-term price swings.
This view is supported by demanding valuations for other mainstream asset classes. There is currently a record gap between economic indicators and government bond yields in the US. Whilst core inflation looks likely remain subdued and the Federal Reserve’s quantitative easing should set a cap on yields, it is difficult to see much progress from the asset class in 2011 and there remains the risk of a significant sell-off if investors start to speculate on interest rate hikes in late 2011 or 2012. With the US economy apparently picking up in the short term, such speculation could pick up over the course of the first half of the year.
Corporate bonds and property remain very hot, bifurcated asset classes which appear to offer little value and should be held for income and the potential for some capital gains in higher-risk areas. On the other hand, the reacceleration of global growth and likely positive earnings revisions are very supportive for equities. Margins should remain high given the lack of wage pressures and M&A should also be helpful. It is quite conceivable that equities and other riskier assets endure a difficult patch early in the year as the markets again test the Eurozone governments’ ability to pay their debts, with Spain and Portugal likely to be in the firing line and force further supportive action from the ECB. The medium-term prospects for equities nevertheless appear strong, at least until interest rate hikes start in earnest in the developed world.
-Peter Toogood, OBSR