After two years of market turmoil and dramatic shifts in indices, 2010 should herald a calmer, steadier performance although economic and financial risks remain, argues Andrew Popper.

After 2008 brought us to the brink of financial and economic disaster, in 2009 we saw financial markets returning to stability and a gradual but clear improvement in economic conditions. Equity markets started the year on a note of doom and gloom, discounting a Great Depression, and reached their nadir in early March. As it became evident that the vast array of fiscal and monetary counter-cyclical measures were going to work, at least in the short run, equity markets staged one of the most impressive rallies on record to end the year with solid double-digit gains.

Equally impressive was the rally in fixed-income markets, especially corporate bonds. Consistent with the negative sentiment in equity markets, the [yield] spreads between high-quality investment-grade corporate bonds and government bonds had widened early in the year to unprecedented levels, in effect predicting massive corporate defaults. As perceptions changed, corporate bonds rallied on an epic scale offering once-in-a-generation opportunities to investors. 

Investments in other asset classes also proved rewarding. Taking advantage of market distortions and reduced competition, a chastised but refreshed hedge-funds industry also delivered on their promises. A rally in commodities - especially gold that reached new highs on concerns over future inflation - provided another set of good investment returns.

After a very painful period for most investors in 2008 and early last year, the picture had brightened up considerably by the end of 2009. Most portfolios will have enjoyed healthy returns from a variety of sources. Clients were generally well placed to benefit from the market moves mentioned above as we gradually increased exposure to risky assets. Higher-risk portfolios often enjoyed returns in double digits for the year, and most portfolios outperformed their associated benchmarks.

Heavy odds
In the New Year the odds are heavily in favour of an economic recovery that will continue to gain traction in response to fiscal and monetary stimuli. Funds earmarked by governments are still in the pipeline and they will boost aggregate demand as they are disbursed. Business inventories declined sharply in 2009 and are now very low. Even a small increase in inventories from such depressed levels will provide an important engine of growth. Similarly, as businesses held back on capital investments during the credit crunch, there is significant pent-up demand for capital goods. These factors will contribute to world economic growth in the year ahead when most large economies will be well out of recession.

To be clear, we do not see in the year ahead significant risks of systemic and widespread problems that may take us again to the verge of a meltdown. On the contrary the outlook is rather positive, on balance. However, this does not mean that the ride towards economic recovery will be smooth and uneventful. Indeed, the road ahead is likely to be bumpy and full of potholes. One of the main negatives will remain the stubbornly high levels of unemployment. This implies further risk of consumer credit defaults for the financial institutions. As a result credit supply will remain impaired as banks will be very protective of their balance sheets.

Central banks will continue to navigate in treacherous waters between the dangers of deflation and inflation and markets participants will be watching them with jittery anticipation. As economic conditions improve, central banks will implement their exit strategies from quantitative easing and will attempt to reduce their bloated balance sheets. First, this implies not acquiring additional assets from banks and second, selling back into the market assets already bought. The European Central Bank has already hinted that operations to unwind QE may start soon. However, other central banks may be less decisive.

The US Federal Reserve is likely to be slower in its approach for fear of stifling the recovery and because of difficulties in finding buyers for assets of doubtful quality. The Bank of England will also find it hard to unwind quantitative easing as it is under pressure to monetise the government’s ever increasing public debt. Thus concerns about inflation further on the horizon will legitimately persist.

Dubai and Greek woes

A big bump encountered recently on the road to recovery was the surprise request made in late November by the state-owned conglomerate Dubai World to reschedule $22 billion of debt, in fact an admission of insolvency. Dubai, one of the emirates which form the United Arab Emirates, has embarked for many years on a major spending spree with borrowed money to build a major metropolis.

Dubai’s credit problems sent shock waves through financial markets reminiscent of the worst days of 2008. In the end Dubai’s cash-and-oil-rich UAE neighbour Abu Dhabi stepped in with a rescue package and the world breathed a sigh of relief. Although the Dubai scare proved to be short-lived and localised, it brought into focus the issue of sovereign risk. Indeed if anyone needs to be reminded, countries can go bankrupt in particular if their debt is denominated in a currency other than their own.

In the midst of the Dubai crisis, major rating agencies downgraded Greece’s sovereign debt to BBB, which is perilously close to non-investment grade. Greece is a member of the Eurozone but if its sovereign debt drops below investment grade it will no longer be eligible as collateral for the ECB, raising the possibility of default.

The creation of the euro-zone has meant that member countries cannot issue debt in their own currency but only in euros, in effect a foreign currency for them that can be issued only by the ECB. In principle, this is a good idea meant to promote fiscal responsibility. But as we live in a world of moral hazard, responsibility is a rare commodity. The weak countries of the euro-zone live and act in hope of finding their own Abu Dhabi should they get in trouble because of fiscal profligacy. However, will the German or French taxpayers (the presumed Abu Dhabis of Europe) be willing to rescue their down-at-heels partners? We will eventually find out, but in the meantime the euro is likely to remain under pressure and investors should steer clear of the weaker sovereign debt within the euro-zone.

Sadly, concerns about sovereign risk have also been raised about the debt issued by the UK government. Indeed UK fiscal spending is out control and deficits have soared into the double digits to levels never previously seen in peacetime. As the UK is not in the euro-zone, the government can issue debt in its own currency and the Bank of England is able to monetise the debt. Thus the risk of sovereign downgrade or default is less pronounced in the case of UK bonds, but investors need to be aware of the risk of capital erosion through inflation.

Steadier returns
The exceptional and unusual investment opportunities of 2009 are not likely to be repeated, but we anticipate the year ahead to produce steady positive returns for many of the asset classes in our portfolios, including equities. We do not believe that the recent equity rally - which has been indeed supported by ample liquidity provided by central banks - has led to another asset bubble. One has to remember that the recovery has started from very depressed levels and we are still well below previous highs. Indeed in most cases we are at the end of a “lost decade” with equity indices still below points reached ten years ago. Moreover, valuations (in terms of price/earnings ratios) are still attractive and likely to improve moderately as the earnings momentum remains favourable.  Investors worldwide still hold an unusually high proportion of assets in cash and they may well continue to redeploy it towards riskier asset classes.

Although equities are not likely to produce the stellar results of 2009 in the year ahead, we expect positive performances from this asset class and are maintaining our exposure at normal levels. However current market conditions call for a more selective approach. In developed markets we will give preference to US markets to which we have assigned a positive grading. Of all the major developed economies only the US is emerging out of the recession with major reductions in unit labour costs and productivity gains. An undervalued currency will also help the US corporations to compete successfully on a global scale.

The large amount of public issuance to cover huge public deficits and concerns about the long-term sustainability of public finances are likely to gradually push up long-term yields in the coming months. As a consequence, we have a negative view on the sovereign bonds as an asset class. We have a more positive view on investment grade corporate bonds for which the risk/reward profile is still attractive.

Good trading and arbitrage opportunities remain in place at both macro and micro economic levels. There are therefore many reasons to believe that hedge fund returns will continue to exhibit their attractive risk-adjusted profile well into 2010 and we maintain our overweight recommendation for this asset class.