If 2008 was the year of terrifying collapse and 2009 the year of the rally on a rising tide of recovering confidence, 2010 is likely to be a year of major turbulence, with big swings in both directions.
The rally in risk assets losing momentum, but not yet over, as I write has been driven by an abundance of virtually-free central bank credit, an unprecedented peacetime spending spree by governments, excellent corporate earnings thanks largely to savage cutting of labour costs, some rebuilding of emptied inventories, and recovery in bank profits thanks to cheap credit, changes to accounting rules and renewed opportunities for speculation.
These positive factors were able to work their magic in a politically favourable environment, with a charismatic new president in the White House, little damage to world trade from protectionism, and absence of any upsurge of political radicalism despite the brutal punishment inflicted on voters by the recession.
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The positive factors will inevitably be less powerful this year.
Tighter credit
Central bankers are likely to spook markets by talking publicly about ending their extraordinary assistance to financial institutions and governments, and actually starting to follow through on the threat.
In the US several of the Fed's emergency-support programmes, those for loans to investment banks, and the corporate-bond and consumer-credit markets, expire soon.
There could be some nominal raising of short-term interest rates already happening in a handful of countries -- with cutbacks in quantitative easing ("printing money") and lending to banks on highly favourable terms.
Central bankers are becoming frightened about the long-term consequences of
Less stimulus
Governments' extraordinary public spending plans will start to lose their lifting-power as they mature. It will become increasingly difficult politically to extend or renew them.
Fears are escalating about fiscal deficits and the long-term consequences for taxpayers of exploding public debt. It will become increasingly apparent how much stimulus has been frittered away on rewarding political connections and promoting ideological objectives.
Tougher business conditions
It must become increasingly difficult for corporations to find ways to cut their costs further except by outsourcing to low-wage emerging markets, a politically explosive process while inventory-building must slow without a strong pick-up in demand for products.
It's an astonishing (but under-reported) fact that in the third quarter virtually all the growth in corporate profits in the US came from the financial sector, with those of all businesses outside finance rising just 2%. Increasingly improvements in corporate earnings are a function, not of improving conditions in the real economy for business generally, but of the extraordinary measures governments have taken to help big banks.
As the positive factors lose their punch, investors will become more conscious of the negative ones.
Storm-clouds continue to hang over the markets
Cheap credit and bank rescues have prevented the collapse of the global financial system, but have not yet addressed its fundamental problems and, in some respects, has made them even worse:
The world's ten biggest banks have an even larger dominance of the system than they did before the credit bubble burst. They now account for 70% of global banking assets compared to 59% three years ago. This is because state support favours big bad banks rather than promoting the expansion of responsibly-managed ones (usually much smaller), or creating new public-service credit-providing vehicles.
This is happening despite general agreement that it's a bad thing to have banks that are too large to fail. They endanger the whole financial system, while their protected status encourages high-risk behaviour that rarely has beneficial value to the community.
Most of the bad debt in the system has not been written off. It's still there, buried in the balance sheets (or in vehicles not revealed by balance sheets) of banks, pension funds and other financial institutions.
This is a heavy discouragement of, or even makes impossible, the new lending to growth businesses that the world economy needs to lift it back on to a path of sustainable wealth creation.
There is also the threat of additional bad debt coming down the track.
In the US alone, in commercial real estate the amount of loans due for repayment or refinancing over the next few years runs into at least a trillion dollars. Yet according to the latest figure I've seen, value of the collateral backing those loans has fallen 40% since October 2007.
In the residential mortgage market the situation is worsening, despite the frenzied and extraordinary attempts of government. In some ways, new problems are being created for the future as we speak. One-fifth of the new mortgages being written with government guarantee are sub-prime!
Rising credit-card delinquencies pile on the agony.
Credit-fuelled asset boom no guide to business fundamentals
Continuing troubles in the credit system are only part of the problem. More worrying and immediate is the threat to economic activity from sluggish demand in the developed economies.
Unemployment continues to rise. For young people it has now reached 20% in Britain; in Continental Europe and the US the figures are even worse. Those remaining in jobs work fewer hours and so earn less. The average number of paid hours of work is down to 33 hours a week in the US, the lowest figure in 60 years.
Families who still have something extra after meeting their basic expenses prefer to use that extra to pay off their debts rather than spend. Massive wealth destruction makes it certain that they will continue to focus in future on saving and rebuilding of personal assets for retirement and medical expenses, keeping down consumption spending.
Few businesses are encouraged to invest in expansion when they are uncertain about sales growth and the threats of rising interest rates and taxes.
Net lending continues to contract in the major economies, while competition for capital from state borrowers, and banks' focus on rebuilding their balance sheets, are likely to push up the cost to the private sector of long-term capital, even without a strong economic recovery.
Asia's emerging economies, the long-term hope for global growth, continue to face the problem of poor demand for their exports, while expansion of their domestic demand is not, and cannot, happen on a sufficiently large scale to offset the sluggishness of the developed economies.
The threatening environment for global growth is likely to be made worse by policy mistakes.
Central bank and government tightening would be foolish (too early) when economic recovery is far from being assured and deflation, not inflation, remains the immediate problem probably for rather longer than is generally expected.
Too much is made of rising fiscal deficits and public debt.
If economic growth remains sluggish, there will be a continuing need for public spending to compensate for depressed private spending.
If growth picks up, government finances will improve rapidly through rising tax revenues and decline in social security spending. That will enable the accumulated debt to be worked off in future as has always happened in the past. The key to excessive public debt is to focus on stimulating economic growth.
The immediate problem with the burden of debt caused by public support is not the debt itself, but that so much of it is being accumulated for poorly targeted spending. Too much for zombie banks and bloated aging industries, not enough in direct aid for consumption, building of infrastructure, job creation, stimulus of small and midsized businesses, and support for higher education -- the engines of economic growth.
With those who brought about, or at least failed to foresee, the credit crisis, still in charge rather than the handful of experts who did predict the crisis and continue to offer many useful ideas on how to deal with it it is inevitable that much policy continues to be wrongheaded.
Political risks
The pain and anger of the public in response to continuing failure is likely to produce political instability. Support will flow to minority parties, most of them with nutty ideas, or to major parties whose only attraction will be that they are not the current lot in power, not their sensible alternative policies.
Two major nations, the US and the UK, face national elections that will make it impossible for their current governments to take unpopular decisions.
There is a real danger that all these problems will fester in a deteriorating international environment.
Negative developments already in train, or ones that could emerge, include China/US antagonism, a currency war, competition for control over natural resources, US foreign-policy failures, Afghanistan/Iran/Iraq tensions, bad-tempered clashes over climate change, and rising protectionism.
The good news is that unpleasant developments are likely to force some favourable changes.
Central bank tightening, for example, is likely to be a temporary phenomenon as it becomes increasingly obvious that it's too dangerous to implement at this stage, encouraging a reversal to cheap-credit abundance.
Backlash will force policymakers to give less attention to populist irrelevancies such as bankers' pay and regulation and to focus on job and wealth creation.
To sum up, I think the key themes for 2010 are going to be:
Disappointment about global economic recovery.
A new bout of worry about bad debt.
Loss of momentum from governments' stimulus plans.
Recognition that Asia won't save the world (yet).
A switch back in focus from the threat of inflation to the threat of deflation.
Political instability, leading to populist initiatives.
A renewed bout of rescue plans.
However, the fundamentally negative outlook for the global economy may not become apparent until we are well into 2010. And even then, many investment markets may prosper.
If central bank credit remains abundant and cheap, that policy will continue to favour speculation in investment assets rather than the intended stimulation of economic activity.
Early signs of change in investment markets such as the recent weakness in China's stock-market and in dollar gold, the shift in US investor sentiment towards lower-risk healthcare and telecoms shares, and the rebound in the dollar, suggest we may be on the brink of major trend changes.
I therefore expect a year marked by three phases:
A continuing but aging rally;
A sharp reversal to the bear trend as sentiment recognizes unpleasant business realities;
Bounceback as (panicky?) counter-measures by government reassert control over the tide of pessimism.
What does this scenario suggest for investment markets?
Most of 2010, I suspect, will be marked by a reversal in the liquidity-driven boom in higher-risk asset classes. That will be bad for equities generally, gold, commodities and lower-grade bonds; good for defensive stocks and bonds, the dollar and the yuan.
However, 2010 could end well, as another rally from depressed levels gets under way.
So now would seem to be time to take some profits out of investments that did exceptionally well last year, accumulate cash, and shape your thinking on which assets to buy when the right time comes.
This article was written by Martin Spring in On Target, a private newsletter on investment and global strategy. Email Afrodyn@aol.com to be included on the recipient list.
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