15th December 2009
- What does 2010 hold for investors?
- Double dips, trouble in the eurozone, and good news for bookies
Dear subscriber,
Welcome to our special Christmas edition. As you may have guessed by the ambitious title, this week I want to take a look at what potential opportunities - and pitfalls - are lurking next year.
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Watch out for the double dip!
Before we take a look at what might happen in 2010, we need to understand how we got to where we are now. At the start of 2009, we were in the grip of a recession triggered by one of the biggest financial crises of the past century. The economy had come to rely on cheap credit to keep growing. All of a sudden that flow of credit stopped, leaving people with a pile of debt that needed to be repaid.
Demand plunged as people lived in fear for their jobs. Firms ran down inventories because no one was buying anything. Banks shrank their balance sheets. And the economy shrank by around 5% in most developed countries.
So central bankers stepped in and pushed interest rates to zero. Banks still wouldn't lend, because they had to repair their stricken balance sheets. So central banks embarked on quantitative easing - or printing money, as most of us would call it.
Governments on their parts increased budget deficits by slashing taxes and raising their spending on special stimulus packages (including incentives to buy cars, and spending on infrastructure, for example). This left most of the developed economies with deficits of between 7-13% of GDP for 2009.
In effect, private consumption and debt was substituted with public consumption and debt. By the third or fourth quarters of 2009, most economies were pulling out of recession. Economies were also helped by firms restarting production in the second half of the year, after cutting it dramatically in the first half to run down inventories.
These measures can't continue
Why is this important for 2010? Because all of these are one-off measures. They can't be sustained. If they are, you can expect the currency of the country in question to plunge in value and for inflation to rise sharply (unless you're a eurozone country which we'll discuss in a moment).
Sooner or later governments will have to withdraw these incentives. Taxes will have to be raised and spending cut to reduce their deficits. The consequences are straightforward. Demand (which was supported by the public sector) will start to shrink again and we are quite likely to end up with a double dip recession, perhaps as early as the second or third quarter of next year.
Consumers are still repaying their debts - at a rate of £700m a month here in the UK, according to the latest Bank of England data. On top of that, credit creation is still anaemic. This is a good thing. It's all part of the process of repairing the economy's balance sheet. But it will take a few years and it will drag down consumption and economic growth in the meantime. The labour market will also be pretty poorly, with most new jobs paying less than what a person could previously earn.
Keep an eye on the eurozone
Eurozone countries cannot devalue the currency. That means any economic adjustment has to take place in the form of lenders charging governments higher interest rates on their bonds. Remember Argentina's crisis in 2001? They in effect had the US dollar as their currency, but they were forced to pay more than 10% a year to borrow. The result was predictable - default!
To forecast a default for one of the big European countries in 2010 may seem quite far fetched. But bear in mind that the way the economy works is not by small adjustments, but by strains building up and then suddenly popping. Watch out for the usual suspects such as Greece, Ireland, Spain and Italy running into trouble. And don't forget their eastern European cousins whose currencies are pegged to the euro (such as the Baltic states and so on.)
Could we have a second banking crisis?
Another threat to watch out for is a second banking crisis. Banks have tried to raise as much capital as they can lately. Here, we've recently covered the Lloyds and ING rights issues for example. But many many more rights issues took place in the second half of the year, from Norway all the way down to Spain.
Yet all it could take to put the banks back to square one would be a second wave of writedowns. That could leave the banks in desperate need of capital - or even a second bailout. So what could trigger such an event?
The first banking crisis was triggered by subprime and Alt-A mortgages in the US. These went bad more rapidly than people were expecting, and could not be refinanced as they became due. This time I think you should watch out for two classes of loans:
1. Loans backed by commercial real estate.
2. Loans to leveraged buy out companies and private equity firms.
Many of these loans were made between 2005 and 2007, and will start to come due between 2010 and 2012. Most will be very difficult to refinance, because the collateral backing them has significantly dropped in value. In the case of commercial real estate, prices are down by 40-50%. This means that the original equity has been wiped out, and the loans are sitting on 20-30% potential losses. That might not seem disastrous, but when you multiply it by the $400bn-$600bn (and possibly more) of loans outstanding, you can see that it could eat up a lot more banking capital.
And if the economy does not recover you can also expect a few more companies to run into trouble - especially those that have been loaded up with debt and taken private by private equity groups. Again, many loans will come due between 2010 and 2012, and they will also be difficult to refinance.
And this time around, if banks run into trouble, a government bailout will be politically impossible. Ordinary people will not stand up for a second bailout after the current row on bonuses and bankers' culture. So if any government decided to bail out the banks again, you could expect riots in the streets, and for them to be ultimately voted out of power.
What does all this mean for markets?
All of this also has implications for the financial markets in 2010. If even a small investment bank were to run into trouble, it might be politically impossible to rescue, and this could cause wild swings in the indexes.
I would not be surprised to see a rerun of February - March 2009 (albeit on a smaller scale). If that happens, we'll keep an eye out for opportunities among companies without too much debt. Why? Because companies that run into problems repaying their debts may be forced to launch rights issues. And as you've seen this year, in the cases of Yell, Lloyds and National Express, a rights issue can have disastrous consequences for your equity holdings, which can be seriously diluted.
At some point I would also expect to see interest rate rises, either because central banks are forced to raise rates to stem inflation, or because the market will finally realize that the risks are too great for the returns that government bonds are paying. Again, we'll be keeping our eyes open for special situations such as the Tier 1 capital issued by the banks. Also this year, junk bonds have made a killing between April and December, and there were some decent stories that could have been played.
How will the election in Britain affect the markets?
The UK will also be holding a general election next year. Lately Labour has been staging something of a comeback in the opinion polls. However, I still think people want change and that Labour will lose the election. I expect we'll end up with either a Tory government or a Tory - Lib Dem coalition.
The best outcome for the markets would of course be an outright victory for one political party. But so far both the Tories and the Lib Dems have sounded tough on the economy, whereas Labour is still preaching its old mantra of spend spend spend. So if the Tories or even a Tory - Lib Dem coalition takes power, I suspect the market will react very positively. I would also expect the pound to surge against other currencies, as the new UK government would be seen as a fiscally conservative one.
What else should we watch out for?
It's worth keeping an eye on the situation in Dubai. It doesn't have the potential to affect the global economy unduly, but it could turn into an excuse for a market correction depending on what else happens there. Other areas of potential geopolitical conflict where I think we should focus include Pakistan which seems to be getting less stable; and Iran, where Israel could launch a surprise attack on the country's nuclear installations (as it has done in the past with Iraq in 1980 and Syria in 2007).
Another area we should pay attention to is South America. Hugo Chavez, the bolivarian revolutionary leader of Venezuela seems to be using the word "war" far too often lately. Venezuela is in deep trouble. A war with Colombia could be enough to trigger falls in regional stock markets and this could create buying opportunities in Brazil, which finally seems to be emerging as a world power.
2010 is also the year of the World Cup and the Winter Olympics, so it should be a good one for the bookies, as people wanting to place the occasional flutter might find it easier to place it in a betting shop rather than go to the trouble of opening an online account. It could also provide some much-needed advertising revenues for free-to-air media companies and advertising agencies.
So we've plenty to keep us going in 2010. That's all from me for this year. I'll be taking a couple of weeks off over Christmas, and I'll be back in the New Year. I wish everyone a Merry Christmas and a prosperous 2010. Remember you can still contact me at eventstrader@f-s-p.co.uk.
Riccardo Marzi
Events Trader
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