Good take on the economic outlook for 2011 from the good folks at Kleinwort Benson. The best news for me in this is that there isn’t much talk of economaggeddon that featured so prominently in the analyses that were coming out of banks 12 months ago. (This might just mean that they have missed it).
- A year quite similar to 2010; investors make money in range-bound trading markets, the unemployed don’t find jobs, credit crises fill the news media
- Continued economic recovery in the West, but steady rather than sharp. Emerging market growth remains strong but may disappoint in 2011.
- Equity markets continue to grind higher over the year, but not in a nice straight line
- After the recent sell-off, government bonds should also offer positive returns in 2010
- Alternative assets offer interesting diversification opportunities
- Gold remains an important insurance policy for very substantial risks that could hit markets
- Western governments and banks need to issue about $5 trillion of gross new debt in 2011. If buyers do not appear for this debt, expect to see more credit crises.
- We remain in a phase of balance-sheet deleveraging in the West – this means the recovery is slow and steady rather than sharp. Growth expectations of 3% in the US and 2% in the UK have been improving recently but are not sufficient to make much impact on unemployment.
- Until unemployment is clearly falling, it will be difficult for Western Central Banks to begin to increase interest rates. If anything the Federal Reserve may seek to ease more.
- Inflation is too high for those who focus on commodity prices , or dangerously low for those (like Central Banks) who focus on the underlying or the core rate of inflation.
- In the short term , emerging markets are suffering overheating pressures and the authorities are seeking to dampen the inflationary pressures (but do not wish to do this by letting their currencies rise). The risks here are that forecasts for emerging market growth in 2011 are too high.
We expect higher equity markets over the year due to:
- continued margin growth on top of the economic growth should deliver healthy earnings–per-share growth.
- This earnings growth is delivering substantial free cash flow for companies, and their balance sheets are in rude health. This opens up the possibilities of better than expected dividend growth, share buybacks and cash-based merger and acquisition activity, all of which should be positive for markets.
- Earnings and cash flow based measures of valuation are below the historical averages, giving valuation support to markets.
Within equity markets , we prefer US smaller companies, reflecting the fact that the US economy continues to receive the greatest policy support, the UK market reflecting its exposure to commodities, its openness to international takeovers and companies that are culturally most likely to increase dividends.
GOVERNMENT BOND MARKETS
- The recent heavy sell-off in government bonds has brought the prices of government bonds back to fairer levels and the expectation of positive returns for the year.
- We are most positive on government bonds from emerging markets, given their high yields, lower debt levels and better economic prospects. They are also denominated in the their own currencies which we expect to rise over the long term.
- UK Commercial Real Estate has a place in income-seeking portfolios, although capital growth prospects are pretty muted. We would stick with high-quality tenants however.
- Commodity prices are a key pressure point for the world economy and are closely correlated to emerging market growth. However if prices rise too fast it will impact economic growth rates
- Market conditions are coming back in favour of hedge funds, as the world outlook gets more complicated than the “risk-on, risk-off” environment that was seen from summer ’08 to summer ’10.
- Private Equity is still adjusting to a changed environment where banks will not lend at previous multiples or previous interest rates. Returns going forward will only be made by those who can operationally engineer their investments rather than financially engineer them.
- The “cheap” major currencies are the dollar and the pound, and their immediate growth outlooks appear relatively healthy. We expect them to perform better than the yen and the euro in 2011.
- We continue to advise holding gold in portfolios as an insurance policy against the very substantial risks that exist today in the financial system.
- Western governments and their banking systems will need to issue over $5 trillion in gross debt in 2011, this is $20 billion every trading day. Issuers that fail to find buyers for their debt may quickly find themselves in a “credit crisis”.
- The biggest risk remains the debt situation in the government and banking systems in the eurozone. EU leaders need to agree a fundamental change in the economic governance of Europe, which will mean Germany paying substantial amounts of money to poorer nations and those nations being told by Germany how to run their economies and how much money their governments can spend. If not the markets will force a crisis and the eurozone is likely to lose members. This would trigger another banking crisis in Europe.
- Inflationary pressures in emerging markets. Governments in emerging markets are very sensitive to rising food prices, and are likely to take strong action to avoid popular unrest.
Protectionism in the US. One of the few things that Republicans and Democrats might be able to agree on is the idea of taxing foreign companies who are subsidised by exchange rate manipulation. It is easily presented as protecting domestic jobs, but is the sort of policy action that made the 1930s such a miserable economic period.