Better late than never, I am happy to share with you my readings of the Street 2011 outlook, updated in February.
First, most of the Street is bullish on the world economy expecting around 4% GDP growth and forecasts a pick up in the US recovery. If you believe the Street, 2011 will be the year of the US. There are some initial signs of a labor market recovery, consumer consumption have rebounded and saving rate seems to stabilize around 6%, ISM index has been expanding for 17 months and bank loan growth has also turned positive. Europe has not yet resolved its problems and three different scenari are conceivable: a) status-quo or a continuation of the current situation aided by global growth, b) an extended bailout by core Europe or a restructuring or c) a deterioration of the situation without intervention from core Europe, leading to an increase in ECB financing and potentially a drastic reshuffle of the EUR.
Upheavals in the middle East have been absorbed easily by the markets and banks are still promoting a bullish case for 2011. Popular trades are:
Corporate exposure:
A preference for equity compared to credit. Banks still expect spreads to tighten but absolute returns are endangered by an increase in rates.
In credit, the Street advocates to overweight high yield compared to investment grade.
Reasons for positive equity returns are the following
- After the recent rally, risk premium remains above average
- P/E are below average P/E during low rates periods
- The economic backdrop is supportive
- Companies hold a record amount of cash on balancesheet (the ratio of cash over assets is 10.7%) and are expected to use it in Capex, M&A and share buy-backs
- Equity outflows in favour of the bond market is expected to reverse and GS, for example, expects $750bn inflows ($125bn retail, $125bn pensions, $150bn institutionals, $350bn corporates)
- Historically, the third year of a recovery or the third year in a presidential cycle are of good omen
- There are still a lot of skepticiism regarding the recovery and many investors have not yet participated to the rally
Consistent with their bullish stance, banks are in favour of Cyclical sectors, Small Caps (which would most benefit from M&A) and high beta stocks in general. This optimism is shared with Core European equities and Japanese equities.
Risks to this thesis exist:
- A US policy gridlock
- Disappointing US economic growth
- European Sovereign crisis
- Municipal finance crisis
- Input cost inflation pressuring margins
- EM inflation leading to monetary tightening and slower EM growth
- Higher interest rates
- Competitive currency devaluation
- Geopolitical risks
Emerging Market Exposure:
The outlook for Emerging Market assets is mixed. Given the inflation backdrop and monetary tightening in those regions, government bond markets do not seem to place to go. As far as equity is concerned, banks have different views. However, we have recently witnessed a rotation from EM to DM illustrated by three consecutive weeks of outflows out of EM after 34 weeks of inflows.
Commodities:
There is unanimity on the upward pace of commodities. Banks still overweight agriculture, outlook for oil is positive, same for precious and industrial metals. Silver is preferred to gold as it is not only a hedge against currency devaluation but it is also used industrially and would benefit more predominantly from industrial growth.
Government Bonds
Not very attractive at those levels but unlikely to drive a high downside as far as Treasuries are concerned. Indeed, the steepness of the curve creates some roll premium. The inflation picture in developed countries is not clear and inflation expectations are wide-ranged. This is a theme that requires a whole post and an increase in rates is one big risk factor for the equity market.
There are some other themes I would be happy to have your opinion on:
- Long US or European financials equity ?
- Do Municipal Bonds (or other related assets) provide a cheap hedge ?
- Do you think volatility looks cheap ?
- Short Apple ?
