World
Factoring in tail risks
From a macro risk profiling perspective there are three key concerns over the outlook for 2011.
The first is the consequence of a sustained rise in bond yields. The surprise announcement of additional US fiscal stimulus in December 2010 was the catalyst behind a significant rise in both US and global bond yields. The rationale for this reversal mainly resides with a recalibration to higher 2011 growth expectations, but there is concern that the expanded fiscal deficit will become progressively harder to finance, implying sequentially higher yields. Rising bond yields would exert downward pressure on equity valuations and strain budget deficits. However, given that the Federal Reserve remain committed to their QE2 programme and will not want to see long term rates move much higher we expect bond yields to remain range bound for the foreseeable future.
The second risk is that Chinese monetary policy tightening overshoots and slows the economy more than expected. While the authorities have been too slow to curb rising inflation and consequently interest rates will increase in 2011, the ultimate objective is to curtail speculative credit growth and not change the 8-9% growth trajectory of the economy for 2011.
The third risk emanates from Europe. Solvency concerns surrounding peripheral Europe persist with the focus progressively moving to Spain. In 2011 markets are likely to force Germany to choose between providing support to a coherent bail out package or face the consequences of a disorderly fragmentation of the euro-zone. Logic dictates they will eventually opt for the former.
At a micro level corporate balance sheets and free cash flow are in good shape and c 4% global GDP growth in 2011 provides scope for subsequent earnings upgrades. Indeed in the UK we are already seeing positive earnings revisions. With most regional market PE's still below their respective 5 year averages the scope for the combination of earnings growth and valuation expansion provides a constructive long term back drop for equities. However, as in 2010 the profile of returns will likely remain volatile.
US
The announcement that congress and the administration had reached agreement on the extension of the Bush tax cuts and unemployment benefits and introduced a surprise 2% cut to payroll taxes resulted in a savage sell off in the bond market with yields on the 10 Yr bond rising from 2.9% to 3.4% in short order. The bond yield reversal reflects a combination of the ratcheting upwards of growth expectations in response to the potential boost to disposable income from the payroll tax cut, and also concerns that the additional fiscal stimulus will sustain a budget deficit in excess of 10% of GDP for the next two years. The ratings agency Moody's has already voiced concern over the lack of fiscal constraint. This criticism could become a recurring theme in 2011. However, the fact that break even inflation rates have remained relatively static while real yields have moved higher would indicate that inflation linked bonds perceive this to have more of a growth than inflationary impact. Given that the Federal Reserve are likely to persist with the bond purchase programme we expect bond yields to remain range bound until they eventually start factoring in interest rate tightening.
The key equity market drivers: liquidity, growth expectations and earnings revisions remain supportive. Valuations also look modest but could be constrained by rising bond yields. Although bullish sentiment indicators have become quite extended the backdrop to equities remains favorable.
UK
Collateral damage to the MPC's credibility
The frustration that that UK inflation data refuses to come under control is palpable and is inflicting damage to the Bank of England's credibility. A succession of exogenous factors such as the oil price, food costs and VAT hikes have contributed to both the CPI and RPI moving well above expectations. While the MPC continue to believe that the UK is facing several disinflationary headwinds (fiscal consolidation, weak credit growth, negative real incomes and a fragile housing market) there is a risk that markets are tiring at their loss of inflation fighting credentials. While they have bought time with the projection that CPI will peak at 3.5% in early 2011, any push back in the timing of the subsequent decline in the 'May Inflation Report' or a surge in inflation expectations could well see the MPC succumb to pressure and begin the process of normalizing interest rates. The first quarter of 2011 will clearly be a very important period in the determination of UK monetary policy.
With two thirds of revenues coming from overseas, the equity market remains more dependant on global growth than the UK economy. Emerging market exposure alone amounts to 20%. Corporations have been delivering strong free cash flow and have strengthened their balance sheets over the past year and enter 2011 in good shape. Encouragingly, after a lull, analysts have started to revise their 2011 EPS estimates higher. A combination of 5% EPS growth and a shift in the current prospective PE of 10.5x to the 5 year average PE of 11.2x indicates 10% upside for the market. With a 3.5% dividend yield the UK market has the scope to deliver reasonable total returns in 2011. The caveat is that as in 2010 the profile of the returns is likely to remain volatile as macro uncertainties (Euro-Zone concerns, UK inflation, Chinese interest rates etc) impact sentiment.
Europe
Euro-zone approaches a tipping point
While the purchase of Portuguese and Irish bonds by the ECB in early December did produce a brief lull in the rise in peripheral bond yields, the announcement that the rating agency Moody's was threatening to reduce Spain's Aa1 rating due to debt funding risks has once again highlighted the structural problems within the Euro-zone. Political schisms, particularly regarding the German reluctance to be seen to be more supportive, have engendered a sense of leadership vacuum.
Spanish bond yields are getting perilously close to the 6-6.5% level that triggers solvency concerns (the inability to shrink the debt to GDP ratio). If this were to arise, the pressure on Germany to agree to an increase in either QE, the EFSF support facility and/or the introduction of a eurozone bond would intensify. Although these are all essentially liquidity measures and don't address the core solvency problem they will be needed to stop a melt-down scenario unfolding. The euro-zone is evidently fragmenting; the key issue for markets is whether this can be managed in an orderly manner over a long enough time frame. It is in Germany's ultimate interest to avoid chaos. The euro has fallen 7% against the US dollar since early November. It looks vulnerable to more weakness in 2011.
Asia
China
The 5.1% November CPI report was significantly higher than expected. Most of the rise was attributable to a 12% increase in food price inflation and core inflation is only a modest 1.9%. Nevertheless, despite increasing the reserve ratio 6 times and increasing the lending rate by 50bp, the authorities are perceived as being behind the curve in terms of adjusting monetary policy fast enough to battle inflation. Consequently, more tightening is expected in 2011. While there is clearly a risk that the tightening jeopardizes growth, the fact that M2 growth is currently 19.5% and not the 30 % seen in 2007 increases the chances that they can still deliver between 8-9% GDP growth.
Japan
The Japanese market continues to be positively correlated to the US bond yield. The logic runs that when the latter rises, signifying an up tick in growth expectations, the Japanese market, which is dominated by exporters tends to do well. Consequently the recent rise in US bond yields has translated into 12% rally in the Topix index. The modest decline in the yen has also helped but the trade data has shown that Japan exports volumes have not so far suffered from the significant appreciation in the yen. Longer term Japan remains hampered by its poor demographic and trend growth profile.
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