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2010: a lost year for equities?

At the beginning of this year, many analysts thought that 2010 would be a year of strong (25%) profit growth, handsome equity returns and meagre returns on government bonds. Looking back, they have been wrong on all accounts. They were not optimistic enough about profit growth, which will surpass 30%, but too optimistic about equity returns, at least until now. And with regard to bonds, they really don’t know what hit them! No wonder that even some of the smartest hedge fund managers have a bad year. If a combination of high profit growth, strong balance sheets and reasonable valuations doesn’t make equities attractive, what does?

Financial markets try to discount the future. They do not care about the present or the past. This has rarely been more obvious than now. Investors ignore the many positives but instead focus on the risk of a double dip.

This fear is understandable. Investors have always known that the second phase of the recovery in developed markets would have to be driven by a pick up in consumer spending. This second phase is now approaching and market participants realise that consumers have little incentive to take over the recovery-baton from the manufacturing side of the economy.

Consumers know that they will face fiscal austerity in 2011. They know that pay rises are likely to remain minimal. They fear that the labour market will not get much better anytime soon. And maybe most importantly; they are starting to realise that they will have to pay the price for an aging society. The likely erosion of pension plans will increasingly be a topic of social debate.

Why would these same consumers start to increase spending now? Some analysts imply that they should, because that is what consumers normally do at this stage of the cycle. But until now, hardly anything has been “normal” in this economic cycle.

In the mean time, the “double-dippers” sell equities and buy bonds, an action which in itself increases the likelihood of the outcome they fear. These investors also realise that governments and central banks have very little ammunition left to prevent such an outcome if it enfolds. Old fashioned medicines like monetary policy (lowering interest rates) and fiscal policy (lowering taxes) have already been exhausted. Only “unconventional” medicines remain, like printing money or implementing unfunded tax cuts. Some countries, like the US and the UK, have already used the printing press quite liberally, but they are confronted with the fact that it is not easy to “force” risk averse consumers to save less and spend more. Therefore, Dr Bernanke may increase the dose of this medicine further.

To conclude, we think that the caution in financial markets about future consumer spending is understandable. Going forward, growth in developed markets is likely to be extremely modest indeed and so is inflation. Bond markets may appear to be in a bubble but we would not count on this bubble to burst soon. Uncertainty reigns supreme, so the future will be about strong diversification and modest returns.

For equities this appears a recipe for a “muddling through” scenario, with slightly more risk on the downside (especially for cyclicals) than on the upside. In that sense 2010 may feel like a lost year for equities. But for the long term, we still think that emerging markets and defensive high dividend stocks offer good investment opportunities.