We live in interesting times. Markets worldwide are grappling with a number of big ticket items that may have a significant bearing on the performance of one’s investments. Navigating through this minefield is going to be critical to protect capital as well as maximise returns. The key calls we see for 2011 are going to centre on:
The bond market – have yields bottomed in Europe and are we going to see the beginning of the end of the bull market that has been around for nigh on thirty years?
Sovereign default in the EU – will it happen?
Currency war part II – and is the euro safe?
Double dip recession?
Equity markets to continue recovering?
Commodity price inflation – still further headroom for commodity prices?
Food shortages? Climate change impact!
Against this background is a growing belief and acknowledgement that the USA is living on borrowed time as a superpower and the shift to the East is now firmly in place. This bloc of nations not only houses the largest mass of population in the world, but the consumption of these same people have turned them into the world’s economic engine, breathing life into the world economy. It is no surprise therefore that companies are falling over themselves to sell their goods to these emerging economies.
It seems that the comfort zone of normality that markets are accustomed to is no longer to be taken for granted. Instead, the new norm is one that is impacted by political decisions. These may come in the form of tax cuts – or austerity programs, intervention to avoid sovereign default, greater or lesser quantitative easing and currency intervention. Whichever they are, each decision will, in some way, impact the investment markets.
Encouragingly, the “normal” economic signals are starting to look more positive. Commentators are today talking less about a double dip recession. Instead the recent news from the US is improving. Forecast GDP growth numbers are being increased and jobless numbers are showing signs of falling. In Europe though, the picture is still mixed. Germany remains the economic powerhouse, and the only major provider of a sovereign financial safety net. The sovereign debt concerns will linger as there is no likely quick fix solution, though Germany is likely to stand by other European nations if push comes to shove. Curiously, Germany is also one of the biggest beneficiaries of a weaker euro and the signs are that further weakness is on the cards.
Against this background, yields on bonds have started to rise – in some cases rapidly. Long dated US Treasuries have fallen over 10 per cent in price terms in just a few months. European bond markets on the other hand have been more sanguine, but prices are also falling and bond yields rising. While in the US the rise in bond yields has largely been attributed to a change in inflation expectations, in Europe it is more to do with a reduction in the credit quality of sovereign states rather than increased inflation expectations.
This does not mean that an improvement in quality will once again lead to rising prices. The fact is that inflationary pressures from commodity prices are building in the system, especially from soft commodities. The UN’s Food and Agriculture Organisation benchmark food price index which tracks the price of corn, wheat, rice, dairy products and sugar shows a 20 per cent increase over the past year and the picture for 2011 looks no better. Food shortages are here to stay.
Consequently at some stage inflationary pressures will seep into the system, even if it is not for some time. The fact is that the market is starting from a point where inflationary expectations were zero. For a bond investor this is worrying, especially those investors who are holding very long dated paper. Beware those investors holding perpetual securities. Prices on perpetual securities (many of which are simply long dated preference shares and not bonds) will be extremely volatile with a strong downward bias.
In an environment awash with cash from the significant quantitative easing taking place on both sides of the Atlantic, equity markets look to be in the sweet spot for the time being. Corporates have restructured their balance sheets and have cut costs to the bone. They are in good shape going forward. Valuations are also not expensive and with the search for yield on there are some attractive dividend-paying stocks out there. Mergers and acquisitions will also play a part in 2011 as companies seek to increase their top line revenue growth through acquisition while consumers continue to repair their balance sheets.
With so many issues to face, portfolios need to be sufficiently robust and well positioned to withstand the cross currents that will inevitably blow through. Opportunities will undoubtedly emerge but managing risk will be just as critical as managing returns.
This article has been prepared by Sandro Baluci of Curmi and Partners Ltd and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
www.curmiandpartners.com
Mr Curmi is managing director of Curmi & Partners.