Global: Market Themes in 2010

• In this article we highlight some of the main themes that will shape market developments in 2010.
• In many ways 2010 is likely to be trickier as many issues will be less straightforward than in 2009. Growth will look murkier and some of the life support to the financial system will be turned off creating uncertainty.
• We recommend a slightly defensive stance with investment in high-quality equities and credit. Bond yields are expected to rise.
• Momentum in the business cycle will likely peak in Q1 and hence the tailwind to risky assets from cyclical momentum will fade.
• On the other hand, sustainability should prove itself with US job growth returning in early-2010.
• The ECB is expected to hike before Fed and the gradual withdrawal of liquidity will remove some of the support from low-quality sovereign bonds.
• The wall of money will still be around in 2010 but not to the same extent as in 2009. Hence bond yields should rise. On the other hand, with very low interest rates the search for yield will continue and support high-quality credit.
• The extent of losses in the banking sector is a highly uncertain factor and markets may become more vulnerable to event risk when cyclical momentum fades.

Five themes that will shape 2010

#1: The peak of cyclical momentum.

#2: Sustainability of the recovery.

#3: Monetary policy exit.

#4: Wall of money and search for yield.

#5: Financial losses to be absorbed by banks.

Theme #1: Peak of the cyclical momentum

Risky assets generally thrive when growth is in the early - and normally fastest - stages of recovery. As this year's brisk recovery has happened alongside massive cost-cutting earnings have been in a ‘sweet spot'. However, much of the fuel driving the recovery is of a temporary nature. The most important factor here is the inventory cycle but fiscal stimulus and the boost to demand from Asian recovery will also fade in 2010. Although we believe other engines will take over and make the recovery sustainable (theme #2) growth is likely to peak at some point.

We believe growth will peak in Q1 10 and that it will level off during the remainder of the year. As the direction of growth is often as important for confidence as the level of growth this means there will be less support for equity markets - especially since equities have reached fairer levels after the strong turnaround this year. Central banks will also stay cautious as they see growth level off again and it will put some limit to how many hikes the markets will be able to price.

Theme #2: Sustainability of recovery

Sustainability will be at the core of developments in 2010. We are currently in a positive feedback loop in which the global recovery has raised confidence in financial markets. And with more companies joining the recovery this is luring out more investment plans and denting the massive job cuts. The next phase of the positive feedback loop is very critical. We need to take the step from job cuts to job growth to bring consumers back on a sustainable path to recovery. If private consumption gets back on track it will unleash more investments in the corporate sector and increase the need for rebuilding inventories. The positive feedback loop continues.

As we have argued previously we believe there is enough fuel in economic growth for job creation to get started (see for example Research US - Job recovery ahead). So far employment data are on track to reach our estimate of positive US payrolls in early-2010 and for it to reach 200,000-250,000 in mid-2010 - especially after the latest job report which showed a rapid decline in job losses in November to only 11,000. There are no indications yet that this recovery will be a jobless recovery as was the case in 1992 and 2002. These jobless recoveries were mainly due to new headwinds hitting the economy (escalation of Savings and Loan crisis in 1992 and equity market meltdown in 2002.)

Theme #3: Monetary policy exit

The pace of monetary policy exit will be important in 2010. Many securities benefit strongly from the current life support - not least in the low-rated sovereign bond space in Europe and CEE - and will receive less support as the year passes. Liquidity measures will be gradually phased out as already outlined by the ECB (see ECB - Heading for the exit) and the Fed, but liquidity will remain ample during the first half of 2010. When it comes to interest rate policy we believe the ECB will hike rates in August followed by the Fed at the end of 2010. The ECB is expected to move first as the slack in the Euroland economy is smaller and the ECB is more concerned about spurring new bubbles.

Our view is somewhat in contrast with market pricing, which expects both central banks to hike around September. Looking further ahead market pricing of central bank hikes will likely rise as the job markets recovery and hence lead to a rise in bond yields. But the decline in growth momentum will put a ceiling on how many hikes the markets will price. Looking into 2011 other contractionary forces from the exit of fiscal stimulus and financial regulation will limit the scope for rapid rate hikes.

Theme #4: Wall of money and search for yield

2009 has been characterised by a wall of money to be invested and at the beginning of the year there were plenty of cheap assets where the money could find a home. This has likely been a major factor behind the strong rally in credit and equity markets, but it also explains why the massive government supply has been absorbed so easily and - in contrast to our expectations - led to a decline in bond yields during the autumn.

So where does all this money come from? The answer is many different places. While governments have increased debt levels, the private sector has offered a large surplus of funds to be invested. Deleveraging pressures have led to a strong rise in private savings and very little private demand for corporate investment, financing of house purchases, consumer durables, etc. On top of this central banks have provided extra funds through their asset purchase programmes. With Fed's purchase of USD1.25bn mortgage bonds it has more or less absorbed all the need for funding in the US housing market. Banks have also been a source of funding for governments as rising liquidity buffers have provided demand for government bonds. Finally, Asian central banks have been a source of liquidity in the bond markets as appreciation pressures have led to more intervention and hence bond buying from the region.

Over the coming year, though, asset purchases from the central banks will stop and we also expect deleveraging to slow somewhat as demand for investment and housing is rising slowly. Finally, we do not expect household savings ratios to rise further. Hence, although there will still be plenty of money in the system it will be less than in 2009. This will put some upward pressure on bond yields and also give less support to risky assets.
That said, the still large amount of money that has to find a home will probably mean that the "search for yield” will come back into fashion and carry trades will dominate for some time, giving support to risky assets in general - not least high-quality credit.

Theme #5: Financial losses to be absorbed by banks

As we saw in late-2009 event risk is far from over. Dubai and Greece serve as prime examples. There is still large uncertainty over the amount of losses that yet have to be absorbed by banks. Key areas of uncertainty are: a) central and eastern Europe (CEE) loan losses; and b) losses on commercial property loans in both the US and Europe.

These developments will be important for two reasons. First, it will affect market stability. Too many negative events could shake confidence and lead to a negative spiral in equity markets - with negative spill over effects in the real economy. Second, it will affect lending standards in the banks. The longer large losses loom the longer it will take to get an easing of credit standards again.

It is very difficult to make a firm prediction of how this theme will play out. In our base case we do not get new incidents the system cannot handle, but it is an area of high uncertainty.

Other important themes

Other important factors include fiscal sustainability, the fiscal exit, tightening of financial regulation and what happens to the US dollar. There are plenty of uncertainties out there and 2010 is shaping up to be another challenging and interesting year. Good luck!

Financial views

Equities

We have moved close to our fair value target and anticipate headwind to take over from tailwind when it comes to further uptrend. We recommend investors to exploit a usual year-end rally to prepare for a rollercoaster in 2010. This involves the following reallocation shifts: a) Move into high quality; b) Move into high yield; c) Move out of high beta; d) Reduce positions in Financials & Industrials. If investors should buy stocks vs risk free assets in Q4 09, it should be: a) Because investors are underweight in stocks; and/or b) Hold a long-term horizon. Otherwise, further exposure to global and local stock markets could be added at more attractive conditions than currently.

Fixed income

Global: We recommend reducing exposure towards the year-end. Position squaring keeps pushing short yields lower. Early next year there is a risk of higher bond yields - in particular in the short end of the US - as the year-end effects unwind. However, we need more clear signals of tightening from central banks to get substantially higher yields and flatter curves. Our medium-term view is for higher yields on a sustainable recovery in the global economy, high supply and the beginning of the phasing-out of central bank measures.

Intra-Euro: We still expect Spain, Greece and Portugal to underperform and on longer maturities, we expect Germany, Italy and the Netherlands to outperform in 2010. Scandinavian government bonds are expected to outperform Euroland in 2010 given the significantly better fundamentals.

Scandi: In 2010 we are overweight Danish callable mortgages as well as capped floaters. We are underweight in Danish government bonds and non-callables. We look for a flatter curve in Norway and Sweden in 2010. We look for wider NOK swap spreads in 2010 and recommend longs in short-dated SEK mortgage bonds

Credit

Going into 2010 we remain constructive on credit. We believe the key to outperformance is to be well positioned for the structural trends in the credit market that have emerged as a consequence of the financial crisis. Overall, we are currently overweight in investment grade and underweight in high yield. Despite challenging fundamentals for banks we believe that senior financials will outperform non-financials as the balance between supply and demand is likely to favour the former. General Industrials and Pulp & Paper spreads have tightened significantly in 2009 and we expect flat or a negative performance in these sectors going forward. We still believe that the underlying credit positive fundamentals for the Nordic utilities are in place but these themes are reflected in current valuations.

FX outlook

The recent dollar rebound looks excessive in our view and we expect it to reverse in the new year. We expect ample liquidity, a still dovish Fed, and risk appetite to take EUR/USD back above 1.50 in three month's time. Further JPY gains should remain capped due to BoJ intervention risks, and we expect EUR/JPY to resume its upward trend. Sterling has received some support from the stronger USD and EUR/GBP has dropped below 0.89.

Commodities

Focus now shifts from common recovery factors to specific fundamentals, such as capacity, demand and inventories for the individual commodities. Oil has found strong support at USD70/ barrel - we see risk skewed to the upside for oil from here.

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