2009 REVIEW & 2010 PREVIEW
Courtesy of The Pragmatic Capitalist
The following is the excellent 2009 review and 2010 preview by PFG Best:
As we approach year-end, I thought it would be helpful to share a quick recap of 2009 and an outlook for 2010. Feel free to call or email me with any questions: Eaven Horter (ehorter@pfgbest.com).
It’s my belief the main market drivers of 2009 were interest
rates and risk aversion. Let’s first begin with the Federal Funds rate. The last elongated period of sub-2% interest rates lasted 3 years – from December 2001 to November 2004. This time period was post-9/11, when our country rebuilt itself in many ways, where low interest rates led to several “asset bubbles” that did indeed end up popping – easy credit and real estate made for a dangerous duo. We are currently just over a year with the Federal Funds rate under 2%, which dropped below the 2% level in October 2008. The current rate was set just a year ago – a historical low of 0% to 0.25%. However, the US economy and global economies are MUCH worse off now then post-9/11. With this in mind, an easy case can be made that Bernanke’s continued message of an “extended period” of low interest rates is truly not just rhetoric.An interesting consideration for this current recession and interest rate scenario is how much more interconnected the world economies are now versus earlier in this decade. What were emerging economies eight years ago are now developing nations, which makes for less of a reliance on larger countries, such as the United States. An example of this is how the world has moved from a G7/G8 focus to a G20 circle, bringing important players into the global economic decision making process. With this interconnectedness, especially in relation to the United States, we saw a focus on commentary and policy from Foreign Central Banks and the large effects these had on global
markets – just look to interest rate increases in Australia and how that affected the value of the USD and the AUD.Luckily, some of us have learned from our histories and we’ve now begun to see lawmakers take proactive measures in respect to asset bubbles. An example would be the development of “taxation” policies to limit the perceived fast and furious growth that has taken place in certain markets, e.g. Brazil. We’ve even seen it here in the United States too, where lawmakers just today began rolling out new regulations to limit speculations within certain markets. In addition to these trends, some central banks are beginning to adjust their own policies given this year’s moves in the USD to counterbalance moves in their own currencies.
Besides interest rates, the interplay between prospective growth and safety has been the other driver of markets this year. As investors have reached for yield, they borrowed USDs (carry trade) and purchased higher yielding assets, such as stocks, and invested in hard assets, such as commodities. Due to commodities direct relation to the USD, economies tied to commodities, such as the BRICs, Southeast Asia and Australia, all experienced strong demand for their currencies. However, when growth prospects were negative/questioned/or a market blip camer across investors’ sights, they rushed to the USD as it has historically been a safety play. Just look at the chart below. Notice the downward trend we saw in the first half of the decade and then look to the bottom seen in March of 2008 and the peak in March 2009.
Yes, interest rates are a huge factor behind these trends, but so is the level of fear present in the markets as well as investors’ desire for risk or aversion to risk. Additionally, as the world does become more interconnected, the United States becomes less a “center of the universe” nation, and our dollar needs to be lower to compete on a global scale given our consumption versus production levels. A prime example of risk aversion within the markets was the market action coming into Thanksgiving – volumes dried up because no one wanted to be active over a long holiday and get caught on the wrong side – and lucky they were! Dubai swooped in with some shocking news, very smartly timed I might add, and the USD again became the safety play. Interestingly enough, this was the first blip of a disconnect of the strong correlation between the dollar, stocks and commodities.
Another component to the markets behavior was the flow of Retail vs. Institutional monies. It’s been interesting to watch the behavior of these two types of investors as institutions have been much more present within the equity markets and retail investors have been much more active in fixed income. Retail investors are still feeling burned and don’t, on average, have the finger-on-the-pulse capabilities of institutions. Also, institutions tend to be more diversified, have better risk management tools in place and focus on a longer investment timeline. This is not to say retail investors haven’t been active in the markets outside of the fixed income arena but they definitely did not feel comfortable within equities and have followed their emotions given near-term concerns. Ironically, as investors flock to fixed income mutual funds to avoid another potential massive drawdown within their equity component, yields most likely will be increasing, whether market driven or policy driven, in the second half of next year and erase the underlying value of their fund holdings. This direct “interest rate risk” associated with bonds won’t be an issue if the bonds are held to maturity but as investors look to reallocate for yield, they may take a hit at that exit point.
So this brings us to one of the largest concerns right now as we approach year end: Portfolio rebalancing. Portfolio rebalancing, year-end and at the beginning of 2010 will and is having a large effect on markets across the board as substantial gains across the majority of markets will lead to profit taking, e.g. gold, with substantial gains meaning reallocation out of the biggest winners into other markets that are more conservative in nature. Massive gains were made in markets across-the-board this year and I would expect for these across-the-board gains to not be easy to recreate in 2010. As always, remember the inclusion of uncorrelated assets within a portfolio of investments is only one key to success. With this in mind, it is important to step back and realize what your investment timeline is and consider entry points based upon how long you’re looking to hold a position. If you stripped out the emotion component, earlier this Spring/Summer was an absolutely amazing time for a long-term investor to put cash to work.
As we step into 2010, I believe interest rates will continue to be the main driver of the global markets, with a focus not just on the FOMC but also Foreign Central Banks. I believe growth will continue to be slow and choppy but I am concerned what the true recovery of our economies has been given the unheard-of levels of government stimulus programs. Stimulus will continue to be necessary and hopefully by the second half of next year, we will be able to begin “The Great Unraveling. It will take years for the world to recover from this crisis, although some economies will rebound much faster than others, especially those that largely steered clear of the credit crisis. One thing is for certain, with an underemployment number of over 17% and an unemployment level close to 10%, our country could possibly need a decade to rebound to the 5% unemployment level given the reduction in leverage/available credit, lack of spending by the consumer and the ominous amounts of debt consumers have accumulated over the last five years.
I am looking for the FOMC to raise rates no earlier than the 2nd quarter of 2010. They are playing a difficult game of taming deflation in America and spurring growth, while avoiding the creation of asset bubbles such as were created by the last extended low-interest rate period. Risk aversion will continue to play out with the USD playing an important role as a safety asset. However, as with investing, nations are realizing that their reserves need to be better diversified and not so closely tied to one economy, the United States. This crisis, in my opinion, has created a fundamental shift in the way global politics work. One bright spot for the 2010 equity markets is after this year’s stellar performance, coupled with continuing positive economic data, the retail investor should play a large part in helping buoy the markets in 2010.
Let me leave you with an interesting analogy for our current situation. Think of the credit crisis as a major earthquake. There’s the major epicenter (the United States), and overtime, there are ripples of aftershocks that permeate throughout a portion of the globe, sometimes across an Ocean (credit crisis spreads to Europe and emerging markets). Once the major earthquake and aftershocks are over, the body count and destruction is tallied, the cleaning process begins and it’s not until sometime later that redevelopment can occur. I liken our current situation to having survived the major earthquake, its subsequent aftershocks and tallies, and now look for us to ride out the last few remaining aftershocks. After these last tremors roll through, which I believe will be in the first half of 2010, the cleaning up process can continue and a foundation for redevelopment can begin by the 2nd half of 2010.
Eaven Horter
ehorter@pfgbest.com
