2011 Outlook

“Prediction is very difficult, especially about the future.” -- Niels Bohr

While 2010 was a respectable year, and in a few instances an excellent one, for most financial markets, it came with the sobering realization that many of the global imbalances investors thought were behind us remain, albeit in a slightly altered form. Which leaves the question; will 2011 be the year when these imbalances re-erupt? I believe the answer is no, at least not during the next 12 months.

For 2011, I believe the overall global economic environment is likely to remain conducive for risky assets. I would expect developed markets to stage steady, yet uninspiring recovery. Growth should be subdued but positive, with inflation remaining low. While rates will rise over time, given low inflation and anemic demand for capital from everyone except sovereign borrowers, I believe bond markets will remain stable enough so as not to derail the equity market rally. In emerging markets, I would continue to expect outsized growth, although that growth is likely to slow as emerging market central banks wrestle with inflationary pressures.

For investors, this means considering an overweight to equities and continued exposure to commodities, particularly the more cyclically oriented ones. Within credit, investors should consider overweighting corporate credit versus sovereign credit.

While cyclical factors should support financial markets for another year, to be clear I don’t believe that the market’s bottom in 2009 marked the beginning of a new cyclical bull market. The debt problems that derailed the global economy in 2007 are largely still present; they have simply morphed from the private to the public balance sheet. Government unwillingness to address these issues, particularly in the U.S., leaves both equities and bond markets vulnerable in the long-term to wrenching fiscal austerity, unexpected inflation, or potentially both. Fortunately, that pending crisis looks like it can be postponed for at least another year.

Volatility

A little over three years ago, the Dow Industrials and the TSX hit an all time high and the list of established Wall Street firms still included Lehman Brothers, Bear Stearns, and Merrill Lynch. In the summer of 2008, most financial participants believed the worst of the subprime crisis had been experienced, world equity markets had recovered, and the US Federal Reserve (Fed) was grappling with the highest inflation in decades. A little over a year ago, financial leaders struggled to prevent what seemed like an inevitable slide toward the first global depression in 80 years.

Three years, three different market environments that experts were mistakenly confident would continue. Extrapolating from the past is a dangerous exercise during even the best and most stable of times. During periods of volatility, it is simple folly. Today, it is no illusion that the world has become more volatile. Consider the following: 10-year trailing U.S. inflation volatility is at a 50+ year high, over the past two years dollar volatility is the highest on record, and gold prices are the most volatile they have been since the mid-1980’s.

Nor is the recent volatility limited to financial markets. The volatility in asset prices has coincided with – orguably been caused by – a similar spike in political instability. The U.S. Congress has changed hands --- Republican to Democrat and back again – twice in a six-year period. This has not happened since the 1950s. At the same time, the U.S. Federal Reserve has tripled the size of its balance sheet over the past thirty months, and plans to continue this exercise through at least the middle of 2011. Outside the United States, the tenure of Japanese prime ministers is starting to resemble that of Italian ones, and an indecisive election in the United Kingdom has produced the first coalition government since the Second World War. Canada and Ireland have minority governments. Politically, economically, and financially we are living in an age of renewed volatility.

The one unqualified prediction that I will make for 2011 is that economic and political volatility will continue. There are three reasons to believe this.

First, many of the global imbalances which precipitated the previous crisis are still around, albeit in slightly altered forms. Instead of a pending subprime meltdown, we have the growing risk of sovereign debt, which will be further exacerbated by aging populations and unsustainable entitlement spending in much of the developed world.

Second, the aftermath of financial bubbles is characterized by slow, anemic recoveries in both economic growth and housing. Both of these will contribute to overall economic and political volatility.

Finally, the ongoing economic shift from developing to emerging markets will be a slow process, one that is likely to play out over decades. As it does, there are likely to be accompanying growing pains.

The good news for investors in the near term is that many of the longer-term imbalances still facing the global economy are unlikely to erupt over the next 12 months. So my baseline view for 2011 is a temporary lull followed by a lackluster but steady recovery in the developed markets with continued low inflation. In the emerging markets, we would expect continued strong economic growth. All things considered, not a bad environment for global equity markets.

Bonds are likely to hold up, at least through the first half of the year, but given valuations and supply issues they don’t appear to offer the best value.

It is important to note that the relatively sanguine outlook for next year does not imply that the global economy has put its troubles behind it. On the contrary, many of the structural imbalances that pushed us into the global crisis are still with us, albeit in an altered form. Ironically, many of the policies that are likely to promote a decent year for economies and markets, i.e. extension of the Bush tax cuts and maintaining transfer payments to individuals (employment benefits in the U.S.), will exacerbate the longer-term imbalances. At some point, the strain is likely to begin to show even on the largest and richest nations, but that is probably not an issue for 2011.