Saturday, January 16, 2010

A year to be particularly agile

Fri, Jan 15, 2010
The Business Times


THE markets for most risk-related trades, from equities to oil to commodity currencies, are likely to push higher in the first quarter on ultra-low interest rates, still ample liquidity, and continued economic recovery.

The key factors that are likely to determine whether the rally continues in 2010 include economic recovery, liquidity, interest rates, corporate earnings and valuations. To date, the economic and earnings recoveries generally continue to meet market expectations. Liquidity continues to be supportive of asset prices. Ultra-low interest rates continue to be an important driver of 'sidelined' liquidity out of money market funds and bank deposits into risky asset markets. Valuations for global equities, using the MSCI World index as a proxy, have yet to reach 'mid-cycle'. But there are wide regional differences, with Asia ex-Japan valuations entering 'late-cycle'.

Investors need to be particularly agile this year. Entering 2010, asset markets are likely to continue where they left off in 2009 - that is, the rally that started early last year is likely to push higher. But this will be a more difficult year than the last, simply because huge gains have already been made and a lot of good news has already been priced into markets. Over the course of 2009, corrections have been shallow, in the region of 7-9 per cent. It was largely a one-way ride on the liquidity tide. Investors will need to be more agile this year.

Eventual exit from stimulus, monetary tightening and policy actions will be key market concerns in 2010. The 'paradox of recovery' - that is, the observation that equities returns tend to be greatest at the early stages of economic recovery and they tend to ease as economic recovery gathers momentum - suggests that gains are likely to be hard fought in 2010.

The following are some themes that are likely to play out this year:

• Equities are likely to push higher early in the year but they face the growing threat of a significant correction some time later in 2010. Concerns are likely to grow over valuations, fading fiscal stimulus, and slowing money supply growth.

• Emerging markets are likely to remain the destination of choice for international portfolio flows in 2010 and beyond. But valuations will look increasingly stretched vis-a-vis global benchmarks as we progress into the year. And any significant correction in global equities will almost certainly cause more damage to higher beta markets.

• Investors need to be discriminating within the emerging markets. We continue to favour Asia ex-Japan for its generally strong fundamentals, and Brazil for its commodities exposure and strong domestic demand.

• Any significant correction in global equities will represent another opportunity to buy back into emerging markets, particularly Asia ex-Japan. Their stronger economic fundamentals should manifest themselves eventually in outperformance after the expected correction.

• Infrastructure spending in Asia ex-Japan and other emerging market economies will continue to offer long-term opportunities.

• Corrections will also offer long-term opportunities in emerging market consumer plays as global rebalancing proceeds - with consumption expenditure expansion in the East playing a greater role in supporting global growth.

• Strong economic growth in emerging markets should provide support for commodities, with corrections likely to be shallow even if there is a general pullback in risk appetites and risky asset prices some time later in the year. Our preferred exposures are copper, lead and oil.

• Temporary US dollar strength will offer diversification opportunities for those with large exposures to the dollar. There could be some weakness in precious metals on US dollar strength, reopening buying opportunities for long-term investors in precious metals. We like platinum as an alternative to gold.

As risk management, investors should consider taking profits off emerging market and Asia ex-Japan equities where the gains from the cyclical bottoms of late 2008/early 2009 have been massive.

Asia ex-Japan led the economic recovery, both in timing and the size of the rebound. And Asia ex-Japan is likely to lead the rate hiking cycle, with rates possibly moving up in China, India, Indonesia and South Korea as early as this quarter. The economic recovery in the US has come later and is more modest. And the Federal Reserve is unlikely to raise the Fed funds target rate before 2011. In that sense, the US is likely to remain in the 'sweet spot' between economic recovery and rising interest rates for much longer than Asia ex-Japan.

Valuations and likely currency moves favour a switch in relative outperformance. Forward price to earnings valuations for both the S&P500 and the Nikkei 225 have bottomed relative to valuations for the MSCI Emerging Markets and MSCI Asia ex-Japan indices. And, indeed, they have been turning around. Currency dynamics are also likely to favour outperformance by the US and Japanese markets vis-a-vis emerging and Asia ex-Japan markets - that is, the dollar rebound of recent weeks is likely to continue through Q1. And recent correlations suggest S&P500 outperformance against MSCI Emerging Markets during bouts of DXY (US dollar index) strength. In a similar manner, we are expecting the yen to weaken relative to the dollar. The Nikkei has been trading correlated against dollar/yen.

Policy rates appear to be at rock bottom and government bond yields are similarly likely to be at cyclical lows. The balance of risk for rates and yields is towards the upside. As markets move to pre-empt rate hikes, we expect flatter curves. Asian economies experiencing domestically led recoveries will be the first to raise rates. Ultra-low risk-free yields in the developed economies are likely to continue to push liquidity into corporate credit. Although corporate credit spreads have tightened dramatically over the past 12 months, they are likely to continue to tighten as the credit markets continue normalising, albeit at a much more moderate pace.

In commodities, demand for crude oil is picking up and crude inventories are starting to fall. This trend should continue and provide support for crude prices, as the global recovery gets underway. We expect a rebound in the dollar in H1, which would create significant headwinds for crude prices. But towards year- end, we expect crude oil to average US$88 per barrel.

Investing in gold has become increasingly compelling as a result of central bank buying and a structural increase in demand for gold as an investment at the retail level. However, upside is likely to be capped over the next 12 months by lower jewellery demand and increased scrap availability as gold prices push higher. Some dollar strength which we anticipate in H1 should also drag on gold, but we expect prices to move higher to average US$1,300 per ounce in Q4 once dollar weakening resumes. Platinum is well supported by the gains in gold, as well as supply issues including rising costs and a vulnerable power grid in South Africa. There are also upside risks from the launch of a US ETF and restocking in the automotive sector. We expect platinum to outperform gold in 2010. Platinum is currently also trading at a much smaller premium to gold than in the recent past.

The writer is chief investment strategist for Standard Chartered Group Wealth Management and Private Bank

This article was first published in The Business Times.

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