Global market outlook

Financial markets experienced a reversal of fortunes in 2009, rebounding after the crash of 2008. The turnaround was triggered by a bout of extreme pessimism in March, the point at which bonds and equities had discounted depression. Once investors regained visibility on the economy and corporate earnings, they were prepared to take advantage of valuations and drive markets up. From then onwards the markets began discounting the economic recovery ahead of the event.

For 2010, the environment is expected to be challenging for most asset classes in 2010. Economic growth is set to slow later on this year and unconventional policy stimulus is being slowly withdrawn. Valuations may start to look a bit stretched in some instances after last year's spectacular rally, but we may still not be in bubble territory yet.

Fixed income

Steep yield curves, falling core inflation, and central banks on hold for an extended period are all supportive forces for bonds. With continued heavy supply, bonds are likely to remain in a range in the first few months of 2010. But with the gradual withdrawal of liquidity, expected towards the end of the first quarter, demand is set to weaken. Bank buying of bonds is also expected to fall significantly this year due to weakening deposit inflows and rising credit demand. Against this backdrop, government bond yields are expected to rise in 2010, with short-term yields rising faster than the 10-year.

Credit

The strength of the credit market last year brought investors record returns. These returns were driven by the severe dislocation in spreads at the beginning of 2009, combined with an aggressive monetary and fiscal response. For 2010, the fundamentals remain supportive, with declining downgrade and default rates to support further spread tightening in credit markets. However, given that returns will not match those in 2009, generating outperformance will increasingly depend on relative value opportunities. Looking across subsectors, the areas that offer the best potential include financials, lower BBB-rated investment grade paper and selective high yield.

Equities

Equity markets are expected to extend their gains this year, supported by low policy rates and further compression of risk premia. Earnings are also expected to increase as the collapse of profit margins over the course of 2008 has effectively increased operating efficiency, allowing company profits to rise much faster than sales. From a valuation perspective, cyclical sectors may start to look a bit expensive. Specifically, the recovery rally may have left the sector at the epicentre of the turmoil, financials, and the two sectors with the most leverage to emerging markets, materials and energy, fully priced. Meanwhile, the sectors with the least leverage to the US economic recovery - telecoms, healthcare and staples - are the cheapest.

From a regional point of view, the best prospects may still lie in the less economically challenged emerging markets, especially those markets such as Brazil and South Korea where the domestic economy is looking in better shape relative to elsewhere.

From a valuation perspective, the Japanese market appears the most attractive. The increased willingness of the Japanese authorities to prevent a stronger yen could be a welcome relief for exporters, which play an important part in the performance of the market. Meanwhile, US corporates have accumulated strong cash balances over the past few months which could be a positive catalyst for the market, particularly if these cash balances translate into share buybacks and higher acquisitions.

At the same time, expectations of stronger US profitability in the coming quarters, due to stronger productivity and lower labour costs, should benefit the market. By contrast, the cyclical nature of European equities suggests this market could benefit from an improvement in activity and capital spending.

Commodities

A key driver of commodity prices over the past year has been the strong demand from emerging economies for commodities such as oil, copper, iron ore, zinc, corn and soybeans. Another important factor has been supply constraints because there has been little addition to existing capacity among developed economies during the recession. In 2010 these two factors could still play a major role. Additional support may come in the form of strong Western demand in the early part of the year.

In the precious metals arena, gold has been responding to low real interest rates, inflation fears and the weak US dollar. However, current expectations are that inflation will surprise on the low side in 2010, undermining the investment case for gold, while the gradual economic recovery will erode its potential as an insurance against catastrophe. The precious metal sector tends to outperform other sectors such as industrial metals during the recession phase of the cycle. Instead, industrial metals do well once we have moved into the recovery stage. Accordingly, the short-term fundamentals for copper appear the most benign, with low inventories relative to consumption, and earlier strikes and other disruptions hitting production.

Agricultural commodities markets continued to underperform the recovery in other commodity sectors last year, with the only exceptions primarily attributable to weather-related supply disruptions. For 2010 strong demand from the ethanol sector and a recovery in animal feed demand are expected to boost corn prices. Sugar too provides a solid base for further price gains after recent supply problems.

The short-term fundamentals for oil remain challenging, characterised by high inventory levels, a firming USD, the potential for a moderation in the pace of economic recovery in the advanced economies, and a weaker OPEC commitment to stated supply cuts. Accordingly oil is expected to trade within a wide band over the next few months. Price downside looks limited below $70 though, as this is the level at which investment will slow significantly.

Foreign exchange

2009 has been a perfect storm for the US dollar. The decline in general global risk aversion and the more aggressive US monetary and fiscal policy stances contributed significantly to the sharp decline of the dollar. The currency should do better in 2010 as growth in the US is expected to outperform both that in the euro area and in Japan. Although interest rates are likely to be on hold in each of the three regions, market talk of tighter monetary policy could still support the greenback. As such, the US currency is expected to do much better against the euro, with the latter considered overvalued by the majority of analysts. In the immediate term, the euro is expected to remain on the defensive amid concerns of a credibility gap currently faced by the Greek government and market concerns over similar budgetary pressures in Portugal and Spain.

After a roller-coaster ride over the past 12 months, the UK pound's fortunes have improved since then and it has generally strengthened since the start of 2010. An end of quantitative easing should reassure investors in the UK worried about inflation and should therefore support sterling.

A millstone around the pound's neck has been the public finances. It is hard to imagine investors' concerns about the UK's fiscal position abating until after the general election, which is expected to take place around mid-year. However, a major fiscal tightening exercise after the election might push the pound higher if it reduced the perceived risk of a sovereign downgrade.

Stronger growth, current account surpluses, capital inflows and earlier rate hikes are all positives for emerging market currencies. Among these, Asian currencies should rally, especially if China starts to revalue its currency. But gains may be capped as Asian policy makers are not willing to let their currencies fluctuate totally freely.

This article has been compiled by the Research & Analysis Unit at Bank of Valletta's Wealth Management. This document is issued by Bank of Valletta plc for information purposes only. It is not and should not be construed as an offer or recommendation to sell or solicitation of an offer or recommendation to purchase or subscribe for any investment. This information may not necessarily be appropriate to your particular investment requirements and risk profile.

It is therefore recommended that if you require investment advice or wish to discuss the suitability of any investment decision, you should seek financial, legal or tax advice from your professional advisers as appropriate. Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report.

The bank has obtained the information contained in this document from sources it believes to be reliable but it has not independently verified this information contained herein and therefore its accuracy cannot be guaranteed. The bank makes no guarantees, representations or warranties and accepts no responsibility or liability as to the accuracy or completeness of the information contained in this document.

The bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. Income from an investment may fluctuate and the price or value of the financial instrument described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Bank of Valletta plc is licensed to conduct investment services by the Malta Financial Services Authority.