Markets: stay defensive in 2011

2010 turned out to be a good year for equities. The FTSE All-World index has climbed by 8%. US shares have gained around 10%, while the main UK and pan-European indices are up by 7%-8%. All these markets are now back to their pre-Lehman levels. Analysts are forecasting similar gains in 2011. No surprise there, says Buttonwood on Economist.com. Strategists always seem to be optimistic. The "typical equity forecast" is "x (where x is the current level) plus 10%".

At first glance, one can understand "the general bullishness", says Buttonwood. Stocks are still in a sweet spot. Ample liquidity, especially after the Fed's latest bout of money printing (QE2), is juicing asset markets. But there is scant sign yet of interest-rate hikes to temper the recovery.

Yet it's hardly as though all is well, says James Mackintosh in the FT. Stockmarkets are "ignoring that fact" that the world's biggest economy remains "reliant on government stimulus". The latest boosts from worried authorities are QE2 and the tax-cut package. If the economy can avoid stalling, it may suffer from "inflation reigniting", says Rob Arnott of Research Affiliates. Any sign of inflation reviving would raise the prospect of dearer money and rattle stocks.

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Meanwhile, the eurozone, "to put it mildly, still has issues", as HSBC's Stephen King puts it. The debt crisis looks far from over and concern over a potential break-up of the single currency area remains a realistic scenario. In Britain a key danger is stubborn inflation eroding purchasing power and threatening private spending amid the public squeeze. The bottom line is that "the Western world remains on economic and financial life support". The East could pose a danger too especially if China can't temper growth without choking it off as it tries to deal with inflation.

There is no reason for markets to race ahead, says Albert Edwards of Socit Gnrale. What we're seeing is a repeat of the 2005-2007 period. In the absence of a genuinely healthy recovery, the Fed is trying to blow up asset markets to boost the economy via the 'feel-good' factor. It ended in tears last time, and it will again, whether the "inevitable implosion" comes in 2011 or not. Given the potential pitfalls ahead, we would stick with defensive equities and hang on to gold.